Brexit and its unknown consequences first dragged down equity markets in an unexpected and largely unpredicted way. This happened because markets had not correctly forecast the Leave vote. But reason can dominate fear over time. Markets now seem to want to take back those losses. Indeed, the early polls gave the markets a misdirection feint, and now, when the situation seems less threatening, at least in the present, markets are trying to shine light through the fog. Still, Leave has won and Remain has lost. It is time to think through possible outcomes from this vote. To do this, however, it is worthwhile to understand the true interests of the principals, the EU and the UK. To put one in the right frame of mind, it pays to think through the following:
Why did the voters of the UK deem it preferable to leave rather than remain1
Why didnt the polls and the other prognosticators (including several quite knowledgeable British politicians) see the risks that Leave could pose 2
Is there a deeper meaning in the lack of a massively supportive Remain vote
In our view, many in the UK feel estranged both from their own leaders and from the Brussels Bureaucrats who make rules that have significant consequences for individuals in the UK without any direct accountability to British voters. When you think about the issue of remote decision-making and a lack of direct accountability, many citizens of the EU actually feel the same way. The EU administrators have chosen what is right for Europeans, but the voters in those countries are very distanced from these decisions. This is politics by imposition.
This is a problem for many countries within the EU. As decision- making has been elevated away from local communities, to countries and from countries to a supranational authority, remoteness and a lack of accountability trouble the average citizen all over the EU. It is no different in the US. Poor outcomes from Government sponsored efforts to change how people and firms behave, coupled to the pathetic performance of Government institutions to raise up the poor, creates broad based cynicism about what Government can really do. The enemy is not some stranger. It is us, in the words of Pogo, from many years ago.3
Governments have constricted the choice space of many firms, households and individuals through restrictions on their freedom of movement; their choices of profession or business activities; through regulations on what and how they may produce, and where production can take place. Indeed, even on the very process of production. We have restrictions on what clean water is to look like and taste like, but no follow-up on deviations from the production of clean water—until a disaster has occurred. Taking control of local decisions means the local decision makers essentially abstain from their control and audit functions.
Government bureaucrats all over the world have decided that the best is what they say is best. Legislators have been cajoled by pseudo science into passing legislation permitting and prohibiting all sorts of activities and then creating monstrous administrative bureaucracies to implement legislation that is often vague and self- contradictory. It is the distance from the rule-making body to the citizen and a citizens lack of review that clutters the free choice space.
Think of the old, but troubled area of zoning. It used to be a totally local affair. Today, it involves a massive regulatory establishment that places localities under constraints with regard to what is permitted even within local zones. Then, think about the huge cross border (national border) movement that disturbs the internal economic and political equilibrium in many countries. Brexit is the first revolt certainly not the last.
The individual has limits on the constraints on his behavior that he or she is willing endure for a broader social purpose. It was one thing to produce legislation. It is another to leave over the administration of that passed legislation to Administrators and Regulators who are typically far beyond the reach of the individual voter. Watching the regulatory upsurge is like watching a snake swallowing a pig.
I am very much a student of the man many call the greatest Liberal in history, Edmund Burke. Burke stood 30 years in Parliament fighting over zealous” reformers who didnt think carefully about the consequences of their “reforms”. He stood against the Crown and the vast majority in Parliament who were urging war rather than conciliation with the American Colonies. Today, we know the outcome was highly positive for America, but Americas growth was not to the benefit of England until well into the 19th century. It took the Souths defeat by the North to clear the air between the US and the UK and for each to enjoy fully expanded trade between their two nations.
Trumps campaign is a great danger to international equilibrium, both because of his unthoughtful proposals but also from the hysteria he seeks to create. Sanders was also a danger. The loquacious appeal that Sanders made to voters to revolt against Wall Street was both misleading and dangerous. A public platform for Socialist nonsense can do great damage, particularly when there is no one else on the platform to contradict infantile economics. Sanders is not just a fool. He is a dangerous fool. His proposals amount to a strong effort to subvert economic growth. Wall Street may well be a greedy environment. It is not a cause of slow growth.
Kill growth and you kill the very mechanism that has made capitalism the greatest anti-poverty weapon the world has ever known. Either Sanders doesn’t really know the true enemy (poverty) or he is just another in a long line of muckrakers whose muck is in their eyes. They are blinded by continual, invidious comparisons between successful and rich people and the poor people who are left out of the increasing bounty of a growing economy. The rants of such social critics make good press copy but increased obscurantism. The crowd is led away from common sense and toward a belief that further regulations will address their fundamental disenchantment with their status. Nothing could be further from the truth.
Regarding regulation, the EU went even further. It coupled the inabilities of nations to secure their borders with increased cross border terrorism. The unwanted terrorist properly documented is free to travel within the EU under the Schengen Agreement. What worked perhaps a decade ago before the Islamic Revolt is no longer acceptable security in many countries. One should be thoughtful about the similarity of complaints in the US and in Europe over immigration.
Throughout the entire history of mankind, people have chosen their friends and their neighbors. Tribalism must have served some function in the progress of human history. When they are now told they cannot object to a new neighbor, it seems as if they are being asked to accept what is strange or foreign to them. They are compelled to accept a new neighbor who may choose to work for less than they do in their own trade. They are thus threatened. Brexit should be seen for what it is. It is a revolt against distant authority over which the British voter had little recourse. The local village is striking back. How people voted on Brexit was graphically illustrated by the voting pattern across the wide geographic span of the UK.
How voters chose was partly a function of the age of the voter. Younger people, equipped with more human capital and less bogged down with the expenses of young families voted to Remain. Older and voters perhaps less endowed with human capital often said No.
In the context of rather unpredicted results in our Presidential primaries or even the quixotic voting indications in a country like Australia, the case can be made that there is growing concern in many essentially democratic countries that Government, is the problem as President Reagan once said. More severe critics simply argue, Government has failed.
The alleged failures include growing income inequality; the appearance that some voices count more than the voices of others; frustrations over immigration coupled to a perceived lack of upward mobility; fears that those who are working might not be able to continue in their good jobs, while those not working might not find suitable employment now or in the future.
One hears globalization on the lips of the forlorn as well as in the voices of leaders who wish to take the fight against globalization and greater economic and political integration into personal political capital. In short, globalization is now the new dirty word of national politics. Keep them out and make sure we get whats rightly ours!
This is not a new cry. We have had riots against machines and cheap imports before. We have heaped blame on newly arrived immigrants who were willing to do physical labor much more cheaply than the existing workforce. The rant against globalization has been around for a very long time. It doesnt mean migration is bad. It does mean that it can be disturbing, particularly to those with lower skills.
At each stage of the worlds integration of trade and finance, some rent holders are inevitably going to lose their presently secure positions while new beneficiaries arise to take advantage of that integration. One can think about the dominance of brand, when one or two brands squeeze out many suppliers in a particular market. Such a process creates many complaints of the losers even though consumers may experience more variety and lower prices. In the early days of Wal-Marts expansion around the country, there were countless complaints that local business could no longer compete. Smaller firms that had supplied similar but not identical services failed because consumers liked the scope of Wal-marts offerings and the prices at which they were available. There are the examples of wounded American steel producers who vigorously complain when imports of cheaper Chinese steel hit the American market. Lesson: both consumers and producers can be turned into dissatisfied voters because their traditional venues of production and distribution are disturbed. When the noise from both sides of the aisle rises loud enough and focuses on a single cause (even if incorrect), passions can be inflamed and voter upheaval is likely to result.
Furthermore, there is the so-called network effect, offered up by social media. Everyone is connected, so one mans beef, is anothers stimulus. Individuals find that their fears are not just their own. There are others out in the ether of the network that are also fearful. Their fears may be different, but that they are fearful is a common ground and provides comfort to separate discontents.
A final point about the inherent confusion of citizens in a rapidly integrating world is the essential unpredictability of their reactions. Look at the just concluded American Presidential primary campaigns. Who could have predicted that an independent socialist who caucuses with Democrats but is an independent, would do so well in the Democratic primaries, running on an ideology that has proven to be a distinct disaster in so many countries Yet Bernie Sanders drew in the young—in large numbers—and the discontented. He crossed older age-determined voting patterns. He drew large amounts of contributions based on small individual donations. That story is yet to be well understood. At the same time, a very rich and raucous political voice that treads daily on traditional political niceties won the popular vote on the Republican side. Trumps outcries were so offensive to some Republicans that they repudiated him and will not support his candidacy. Then there are the more obvious complaints from minority groups and women. Yet, in some polls, Trump is not running distinctly far behind Clinton. That ought to tell us that traditional political prediction models may be truly misleading going forward.
Finally, try a simple thought experiment. Look at a nominally successful growth story like China, albeit slowing as it is today, and ask, what would a massive, free political campaign show if the question were, whom do you want to run the Government of China: the Chinese Communist Party or a number of freely electable parties with divergent views of a proper democratic setting Not that there is going to be such an election in the future, but one might ask how would such a vote turn out Looking around the world, I think you get a clear answer. There would be supporters of both the CCP and supporters of every other party that put a candidate in the field. But it is not clear that a plurality would vote for the non-communist parties, even though we in the West would like to believe that a party that brooks no independent thought could never be a majority party!
Why wouldnt all people choose freedom over dictated choice Because with Freedom, comes uncertainty! Uncertainty is painful in markets. It is discomforting to many in the electorate. We cant be sure of the outcome. All we know is that in a democratic society, we are free to change our minds and change the political leaders who will govern policy. But elections and governance feature the same possibility: Uncertainty. The content of the policies we vote for may not be what we expected and there are always unintended consequences of policies that are chosen.
If you think of the Brexit vote, you get a clear insight into what representative government truly means. In the UK, the voters were offered a choice to move away from known uncertainties and known benefit structures. They cast their vote for unknown unknowns.4 What they will get may be far different from what they expected.
It is clear however that the vote sign signifies that there is a large measure of dissatisfaction in how life is experienced today in the UK as a member of the EU. The EU became a target for that dissatisfaction even though now there will be considerable uncertainty as to who wins and who loses. To get a good result, there has to be a willingness of the voting population to give up what they know and hope that what they dont know will be better.
One cannot imagine such a vote actually taking place in China now or for decades into the future. Freedom to choose means freedom to change and change is not costless. The cost is that one can never be sure if the political structure to which one is accustomed, could be radically changed tomorrow. Democratic States are loud and noisy and we should remember Brexit because these states are not always unchanging, rock solid masses of a single political opinion or insight. The thought experiment tells us a lot.
The Chinese get restricted choice but certainty of political outcome. If they are uncertain, it is over whether that outcome can ever be changed and it would seem that broadly speaking, they dont think that it can, otherwise the clamor for change would be far more widespread. Yet, there is evidence of the level and extent of their discontent. Look at the massive capital outflow that China has been facing recently. Chinese savers are voting with their feet, and the bureaucrats in Beijing are worried about that. Chinese are worried that the future in China could turn out to be far different than the recent present.
Interpreting Markets and the BREXIT vote. The Unknown Unknown suddenly popped up and dismantled our previously held certainties. Equity and bond markets first went into a tizzy. Despite their recovery, in recent days, markets are nowlikely to be quite volatile in the future as the geopolitical fog into which we have now plunged may not soon lift.
We have no particular insight as to how the Europeans (now badly kicked in the shins) will react to their rejection. One thought is they now have to contend with the possibility that other nations within the EU will also try to escape. There is talk of that in the Netherlands and Denmark and Italy. The French and the Germans wont want that to happen and may decide to punish the UK, but that is a strategy fraught with nastiness on both sides.
There is also a leadership crisis in the UK with dissenters (Remainers) in both the Conservative and Labor parties. Affection and disgust for the EU and all it stood for was not a partisan affair. There were Leavers and Remainers in both parties. The English political system now confronts a sitting Prime Minister who has notified the public of his intent to resign in three months. So not only is direction in question, but who the captain of the ship leaving the EU will be is open.
Speculation on what the EU will do is dominated by fears that other EU members wish to depart the present political and administrative vision that dominates the bureaucracy in Brussels. The French-German alliance that is the keystone of the EU will take considerable pressure to remain the foundations of the EU.
Each of these unknown unknowns, and unknown knowns create uncertainty. Economic growth is likely to be retarded as business investment slows. The Goldman Sachs forecast for the UK has reduced 2016 growth (reduced by 0.5% to 1.5%) and 2017 growth (from 1.8% to 0.2%), lowering GDP by 2% over the next two years. Goldman also expects the BOE to reduce their policy rate by the July MPC meeting. All in all, GS is predicting a technical recession in FH 2017. Corporate leaders dont yet know how to plan for this kind of an uncertain political and economic environment. Added to the uncertainty, is the US Presidential campaign is soon to get underway in full stride after the (foregone) conclusion of the two political conventions. Will US Trade policy be restructured since both presumptive candidates are calling for reworking the present TPP agreement Blaming the foreigner and foreign trade has become the currency of the realm in both the UK and in the US.
The forthcoming negotiations between the UK and the EU will be a highlight of the developing scenario, except of course at this point we dont know who will become Prime Minister when Cameron steps down. Nor do we really know what the key members (Germany and France) will do when the UK finally sits down to negotiate its exit.
As Henry Kissinger pointed out in a recent Wall Street Op Ed, the UK and Germany are quite important to each other with regard to trade and with regard to NATO foreign policy.5 There is both opportunity and potential pitfalls. Whether their respective leadership will focus on what is jointly important to each or whether the EU will turn to a punishment scenario depends critically on political leadership. Little will be gained from the punishment scenario, but there is considerable fear in the EU that a weak reprimand of the UKs exit may prompt other restive countries in the EU to seek their own exits. Never has political leadership been more important.
- The voting analysis is just beginning See http://www.theguardian.com/politics/ng-interactive/2016/jun/23/eu-referendum-live-results-and-analysis [↩]
- The NY Times reported that in fact 15 out of 35 surveys showed exit while the remaining 17 showed remain. Clearly, there was a large division of opinion that was shifting on a daily basis. Perhaps in light of the collapse in the price of equities, the question is why did markets fail to take into account the non-trivial possibility that Remain would fail Maybe this was a case of market player not being willing to face the uncertainty that an Exit vote would imply [↩]
- I have seen the enemy. It is us. [↩]
- Former Secretary of Defense, Rumsfeld, was quoted as saying, Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.
- Henry Kissinger, Out of the Brexit Turmoil: Opportunity, WSJ 6/28/2016 [↩]