Brexit Impact – Economic Memo #51

I am a senior in high school and across the lake that abuts Hobart High the water tower stands tall. The football quarterback’s name written in gold and blue (school colors) glares in the sunlight for all to admire at the top of the tower.

Now I have to tell you heights are not my favorite thing. You’ll never catch me on that Willis Tower platform, looking down through the glass, “isn’t going to happen.”

So I decide to enlist three of my buddies to climb the water tower and replace the quarterback’s name with ours. Climbing the tower was a challenge. We marshalled our forces, and one of the guys bought a gallon of iridescent orange paint. I put on my brand new light blue fall jacket that I really liked and headed out telling my mother that my buddies and I are going to a speed reading class that we were taking at Valparaiso University.

Of course the class had been cancelled that day, so off we went to the park where the mountainous water tower stood. Someone decided it would be too hard to open the paint can on the small platform at the top of the tower, so we opened it on the ground.

The first obstacle was a barbed wire affair meant to keep jackass kids from climbing the tower. One of my buddies had brought a blanket to throw over the barbed wire and that worked well. We started our climb. The fellow in front of me carried the open can of paint. I had the brushes and two buddies followed.

After about two hundred feet in the air, which felt like the top of Mt. Everest, I was thinking this wasn’t a good idea. At three stories I felt the wet globs hitting my new jacket sleeve, and then on my head and face. I thought it had begun to rain which was a great excuse to climb down. But I soon realized that if rain was iridescent orange, I was okay. Otherwise my buddy had spilled the paint can all the way down the ladder and all the steps down were going to be slippery.

As you guessed we never made it to the top.

Now the next morning, I woke up and thought to myself, “Did you really do something that stupid?” The sum and substance was the story got around the high school quickly and my sister told my mother that I ruined the new jacket. Now I felt really, really, stupid.

That has to be the feeling of the British the morning after they voted to leave the European Union, and it will get worse as time goes on.

The Economic Theory

Countries combining into economic unions is forced upon them by the fact that they can’t take advantage of specialization unless they combine.

Remember an economic theory starts with simple case assumptions. In this case assume only two countries (England and France), two goods (Scottish wool sweaters and French wine), each country producing both goods spending the same time on each product. One-third on wine production and two-thirds on sweater production.

Let’s also assume that the Brits are better producing sweaters and the French are better at producing wine, and after specialization you have to have a least as much wine and sweaters as you had before. It looks like the table below before specialization and after specialization. You can see by specializing that both countries are better off by 90 bottles of wine. This is named absolute advantage.

Economic memo 51 -a
You might want to ask, “What happens if France is better a producing both goods. Should it specialize in what it does best and England specialize where it has the least advantage?” The answer to that one is “yes.” This is called comparative advantage.

 

 

Economic memo 51 -b

The whole idea of the European Union economically was to take advantage of specialization and drop all “extra costs” that get in the way of specialization. A tariff (tax on another countries goods) hurts specialization by adding cost to the lower priced item from another country and protects the inefficient company at home making that product. Separate currencies mean that companies right across the border from each other have to buy insurance to protect from swings in the values of the different currencies.

Now can your small economy exist on its own? An analogy would be if each of the states in the United States had their own currency, laws, passports, etc. How long could Illinois put together cars with parts from Indiana, if Illinois had a tariff on Indiana auto parts? It just doesn’t make sense, especially in a global economy competing against China, United States, and the European Union which loom over you.

So one thing is for sure. The Brits decided that they will protect jobs at home by setting tariffs and their own rules for production, product safety requirements and the like. I don’t think they realized that the price of those inefficiently produced items will go up. (I always ask my classes, “Which would you rather have? A toaster made in Mexico or China for $10 or one made in the United States of $40?” Not surprisingly they always choose the $10 toaster. The Brits just chose the $40 toaster.)

 Impacts on the United States and Europe

 1.0 Immediate drop in 401K values should be temporary (Don’t panic yet)

Well anyone with a 401K or 403B knows the immediate impact on them since Friday. U.S. stocks suffered the largest selloff in ten months, with the Dow Jones industrial average losing 3.4 percent. Stock markets don’t like uncertainty and the Brexit causes everyone to question if the European Union can survive. World stocks saw more than $2 trillion wiped off their value. European stocks ended down 7.0 percent, the biggest one day falls since 2008. So money flowed to gold. Once the panic subsides the market should recover, but when that will happen is the question.

Basically what happened Friday was the surprise that ‘stay in the Union’ did not win. Most of the market movers and shakers were confident Britain would not leave. As a result, the market was surprised and fear and uncertainty set in. The market reevaluated the risk higher, so stocks were lowered.

2.0 How will it affect consumer confidence and spending?

Plunging stocks certainly won’t bolster the confidence of United States consumers, whose spending accounts for about 70 percent of United States economic activity. The NASDAQ index, which is heavy on technology stocks, fell by more than 4 percent. If you feel less wealthy because your portfolio has dropped then you will spend less, especially on electronics, and the economy will not be as healthy. This is currently an unlikely scenario since most experts see the market as returning to normal in a few weeks.

 3.0 Immigration

Brexit, would allow England to greatly reduce the inflow of legal migrants — an argument that resonates in a country where antipathy toward immigration has grown in recent years. Would that increase pressure the United States to take in more Middle Eastern refuges? It may increase world pressure but it’s unlikely to happen.

4.0 Lower interest rates impact on savings, mortgages, and stocks

MSN.com reports the following:

Uncertainty over how the global economy will cope with the changes in Europe may cause the Federal Reserve to stay cautious, and wait before raising its benchmark interest rate any further this year. This will have three impacts on the US economy.

  1. Mortgage rates, which were initially projected to rise this year when it was expected that the Fed would raise short-term rates, may actually fall further. The average rate for a 30-year mortgage fell slightly, by 0.1 percentage points, after the Brexit announcement on Friday. This should be good for mutual funds and stocks tied to the real estate industry. For people who have been waiting to refinance their mortgage, now may be the time to act.
  2. Since cautious Fed policymakers now are unlikely to raise a key interest rate next month – or maybe even for the rest of the year – it denies savers a better return on their bank accounts. Brexit offers little relief for consumers who are tired of earning next to nothing for the money they have in the bank. At an average yield of 0.08 percent, the payouts on savings accounts are still pretty close to three-year lows, according to Bankrate. And with it now looking less likely that the Fed will raise short-term rates, savers should not expect those yields to increase substantially any time soon.
  3. When the Federal Reserve raises interest rates it indicates the economy is getting stronger. The demand for goods is greater than the supply and prices start up. Monetary policy then dictates a higher interest rate. In this case they are not raising the rate as they said they would. The result is not validating a strengthening economy.

Finally, in the near-term, the ripple effects of the Brexit may be felt beyond retirement accounts and lower mortgage rates. The weaker Euro and Pound Sterling means a stronger Dollar that boosts Americans’ purchasing power. The impact of that is in the next section.

5.0 Travel to Europe

There is one bright spot for Americans planning trips to England and other parts of Europe. The British Pound plunged more than 10 percent after the decision, leading to the biggest discount against the dollar seen in roughly three decades. The Euro slipped 2.0 percent against the U.S. Dollar.  If the Dollar maintains that advantage against the Pound and Euro, it could essentially lead to discounts for Americans traveling to Britain and Europe.

MSN reports: it could become cheaper for Americans to fly to Europe if Britain’s move leads to slower economic growth abroad. Round-trip fares to main destinations in Europe including London, Amsterdam, and Madrid are already falling. For example, a round-trip flight from Chicago to London was going for about $580 for travel in the fall on Friday. Prices could sink further if Europeans cut back on their travel to the United States, because airlines might be tempted to discount those flights for Americans in an effort to fill those empty seats.

6.0 Capital will flow to the United States

            Since Britain is now a riskier investment and volatile market, the United States will benefit since investment money will flow to the more stable environment in the United States. This should help our investments in the long run.

7.0 Brits have a real problem

Ratings agency Moody’s downgraded its outlook for Britain assigning a negative outlook to its ‘Aa1’ rating for British government debt, saying its creditworthiness was now at greater risk as the country would face substantial challenges to successfully negotiating its exit from the bloc. This will mean that England’s debt financing will be more expensive.

The United Kingdom itself could also now break apart. The nationalist leader of Scotland, where nearly two-thirds of voters wanted to stay in the EU, said a new referendum on independence from the rest of Britain was “highly likely.” Scottish government ministers were meeting on Saturday to decide their next move.

Quitting the world’s biggest trading bloc could cost Britain access to the trade barrier-free single market, and means it must seek new trade accords with countries around the world. A poll of economists by Reuters predicted Britain was likelier than not, to fall into recession within a year.

Older voters backed Brexit but the young and well educated mainly wanted to stay in the European Union. London and Scotland supported the European Union, but swathes of England that have not shared in the capital’s prosperity, voted to leave.

Left unclear is the relationship Britain can negotiate with the European Union with officials warning UK-based banks and financial firms could lose automatic access to sell services in Europe.

Huge questions also face the large numbers of British expatriates who live and work freely elsewhere in the European Union, as well as the fate of European Union citizens who live and work in Britain.

 

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at obrientr@lewisu.edu. Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

Leave a Reply

Your email address will not be published. Required fields are marked *