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The Good News and the Bad News for the Post-Referendum Economy

24/06/2016 16:18 | Updated 24 June 2016
Andrew Holt via Getty Images

Popular cultural images are enduring. Panic on stock markets probably evokes images of the run on Northern Rock, or Lehman Brothers employees being ushered from the building. That is why people could be forgiven for thinking that the panic on global financial markets after the UK referendum will immediately result in very obvious changes to their banking practices and their everyday lives.

But there are a number of reasons why the effects of the UK referendum result will be noticeably different. Number one is that British banks learned important lessons after the crisis, as did the regulators. The result is that, in technical terms, they are now better capitalised. In layman's terms, the banks themselves are far less likely to be at risk of collapsing and requiring taxpayer bailouts. And this was one key message from Bank of England governor Mark Carney early on Friday morning.

Number two though, central banks have also learned important lessons in recent years, and the Bank of England in particular had a dry run of Brexit in the Scottish referendum of 2014. The Bank of England learnt that for British banks to be able to maintain business as usual they might need to have access to extra liquidity (in layman's terms, funding). In the lead up to the Brexit referendum then, the Bank of England introduced another set of these extra liquidity operations. And, if we are to understand the Governor correctly, the BoE will continue to extend these operations in the short term to make sure that the banks keep providing services to businesses and individuals.

The good news then is that this is not likely to be a banking crisis like that which we witnessed in 2008.

The bad news though is what comes after the initial 'shock' has passed. Because even if the Bank of England looks set to be able to weather the immediate storm inflicted by stock markets, the longer term implications look far less certain and far more challenging.

There are a number of important issues that are worth restating: to begin with, and rather unhelpfully, we simply don't know what the impact in the medium to long term is going to be. There are no previous examples to draw upon. There has never been an example in history of a country the size and status of the UK leaving an economic block as developed as the European Union. Relatedly, we also don't know exactly what the future trading relationships between the UK, the European union, and the rest of the world, are going to look like.

Based on the available information we do have though, it seems reasonable to surmise the following in the medium term: arguably even more important than the end deal itself which the UK manages to negotiate, is the degree of political and economic instability which will inevitably come in the next few months. The Bank of England and it's governor Mark Carney have extensive experience of managing uncertainty; and David Cameron has done the right thing by reassuring markets that there will be no immediate change in Conservative party leadership or an immediate invocation of Article 50 to begin the divorce with the EU. These points are important, because any sudden moves would only exacerbate the uncertainty of investors and firms.

What is almost certain is that the kinds of falls in sterling that we are already witnessing will lead to conflicting pressures for the British economy. Over the coming months the drop in sterling may look like a good thing. It will boost exports and quite possibly reduce the financial stability risks of the UK's current account deficit. But since the UK actually imports more than it exports the positive gains of a lower sterling will likely be more than offset by rising inflationary pressures. The Bank of England will need to walk a tightrope. It has little room to lower rates, though the economy may need the boost - particularly if confidence and investment falls. And it will almost certainly resist immediate rate rises - which would choke off any economic growth altogether and threaten fragile and indebted households and spending.

The likelihood is that the Bank will introduce another round of Quantitative Easing to boost the economy. The effects of QE are very questionable, but the idea (in principle) is to encourage the banks to lend more to the domestic economy and help the recovery. And this seems to be what Mark Carney was referring to when he suggested that the Bank of England would 'assess economic conditions' carefully over the coming months and take whatever action it deemed appropriate. Whether another round of QE will be effective in sustaining the UK economy is open to debate. The available evidence though suggests that it will not be.

There is also the question of the future of the City of London. The likelihood though is that the City will be one of the parts of the British economy that does the best out of the Brexit deal. It has always operated with a kind of offshore financial status and, as we are seeing with the current stock market crash, many parts of the banking system actually thrive on this kind of instability. The nature of the activities taking place in the City may change, but its status will likely remain intact.

The sad truth for the UK though is that none of this is really great news. The British economy is already unhealthily imbalanced towards financial services. And the kinds of uncertainty involved in drawn out trade negotiations over the next few years will be hard for most of the British, export oriented, manufacturing sector to weather.

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