BRITAIN STUNS WORLD WITH VOTE TO LEAVE E.U. is the headline on the New York Times homepage. Stock markets plunged, the values of the pound sterling and of the euro relative to the dollar fell sharply, and Prime Minister David Cameron announced he would resign by October.
So, where do we go from here? I’ll discuss this question with Roshini Rajkumar on WCCO Radio this Sunday at 12:35 CDT. For now, three items bear watching in the coming days and weeks.
You’ll hear this phrase mentioned repeatedly in the coming weeks. It refers to Article 50 of the EU’s Treaty of Lisbon. The Treaty of Lisbon is the governing document for the European Union, and Article 50 is the clause in the treaty that sets out the terms under which a member may leave the EU.
The next step for the British government is to inform the EU that they are invoking Article 50. Once this is done, the EU and the UK have two years to negotiate the terms of separation between their governments. If they haven’t reached agreements in two years, then they can mutually agree to continue talking or simply separate abruptly with relations reverting to those between any two sovereign states.
The referendum did not trigger Article 50; rather, it set in motion a chain of events in which parliament must vote on whether or not the Prime Minister should tell the EU heads of government that Britain will invoke Article 50. Boris Johnson, the former mayor of London and likely Prime Minister, said this morning that there is no rush to invoke Article 50 and so relations between the UK and EU will not change for the time being. But, the reason Prime Minister Cameron is resigning is that he does not want to lead the fight to win this vote, so no one knows when this debate will occur.
No EU member has invoked Article 50 and how the British government will proceed adds to the general uncertainty generated by the referendum.
Financial market volatility
Stock markets, bond markets, and currency markets were unanimous in their forecasts before Thursday: The vote would be close, but Britain wouldn’t vote to leave. This meant that a vote to leave was not priced into investors’ expectations about these asset prices, and when these markets opened today the participants were flailing about trying to make trades.
Now that the Leave side won the referendum, financial markets need time to find their long run prices for stocks, bonds, and currencies. No one knows what these long-run values will be, so there will be much buying and selling, driving prices up and down, for the foreseeable future as everyone gropes towards equilibria in these markets.
In the short run, money managers are moving their funds to safe havens such as US. This has three effects. First, in order to park their funds in the US, money managers need dollars, so they must sell British pounds and euros in order to get their hands on them. This increases the supply of pounds and euros available, and drives down the values of sterling and the euro versus the dollar.
Second, the declining value of the pound, and conversely, the increasing value of the dollar, means that US exports will become more expensive and imports into the US will be cheaper. Thus, American exporters will have a tougher time selling their goods and services in Britain and in Europe, and will make imports from those places more attractive to American consumers. The result will be a bigger US trade deficit than otherwise would have been recorded.
Third, US interest rates will fall due to large British and European purchases of American bonds, especially Treasury securities. For example, the yield on 10-year US Treasury bonds today is 1.565%, compared to 1.69% on Wednesday. This is one reason why the Federal Reserve chose not to raise its target interest rate last week; if they had, the Fed would probably have needed to reverse their decision today.
International trade relations
Britain shared a common trade policy as part of the EU but now must sort out its relations with the US, Canada, the EU, and every other country in the world. What Britain will do is anyone’s guess due to the wide variety of options available to them.
One possibility is that Britain will join the European Free Trade Association (EFTA). This would allow the UK to continue as part of the European common market but like the other EFTA members they would have no voice in forming European trade policy. This, to me, is the most likely scenario as it would minimize the number of new trade treaties Britain would need to negotiate. It would also make sense as the UK was a founding member in 1960 and only left in 1973 when it joined the EU.
Another option is for the UK to negotiate bilateral trade agreements with the US and other important trade partners, then follow the rules of the World Trade Organization for all other countries.
Concerns about Immigration, probably the biggest issue in the campaign, loom on the horizon but right now Britain needs to get its financial markets calmed down, sort out its Article 50 application, and figure out how to proceed on trade before it tackles this problem. Keep in mind, however, that concerns about immigration will not go away and may get worse while the Article 50 negotiations take place.
Hang on for a bumpy ride in very choppy waters.