Much has been said and written about the effects of the (presumed) British exit from the EU. What is clear is that uncertainty is the driving force behind the economic effects to date. So any analysis must first start by examining the sources of uncertainty caused by the vote. This blog post focuses on the sources of uncertainty, the culmination of that uncertainty in market outcomes, and the potential effects on Texas.
Indeed, there are many unanswered questions. Foremost, if the UK leaves the EU how will new trade agreements with the EU compare to the current trade regime? Which goods will face higher tariffs? At what level will the British pound stabilize relative to the U.S. dollar, the euro, the yen and other currencies? The answers to these questions will be important in determining how the decision to leave the EU will affect the UK. But there are other questions as well, many of which are political in nature. Will other EU members also seek independence? Is a monetary union without a fiscal policy union stable in the long-run? Will Scotland seek independence from the UK in an effort to remain part of the EU (note that in Scotland, the vote was 2-1 to remain in the EU)? Who will be the new prime minister of the UK? All of these questions contribute to an immense amount of uncertainty in terms of how the markets for goods and services in the UK and EU will be organized in the future. This uncertainty makes it more difficult for businesses to make long-run decisions, and thus creates uncertainty in business decision-making and planning.
We have seen large movements in stock prices and currency values since the UK voted to leave the EU. One result of uncertainty is more volatility in prices. This explains why the vote caused stock prices to decrease significantly initially before rebounding to near pre-vote levels. This volatile movement in prices is driven by fear or apprehension, as well as complex mathematical formulas, as investors react to market uncertainty. This type of price movement is inherently different from price movements that are related to a change in economic fundamentals. For example, after the vote the British pound weakened substantially relative to other currencies. Relative to the U.S. dollar, the pound fell from $1.50 per pound to as low as $1.31 per pound, before rebounding to $1.35 per pound. This has led to changes in the economic valuations of firms. We can see this by examining a basket of UK exporter stocks (created by J.P. Morgan) relative to a basket of UK investment sensitive stocks (created by Goldman Sachs). The stock prices of the British firms that export most of their products are up by about 10 percent near the end of June, while the stock prices of the firms that are sensitive to UK investment levels are down by about 20 percent near the end of June. This is consistent with the fact that exporters benefit from the lower value of the pound, which makes the goods relatively cheaper for those who demand their product. But this points to an important problem caused by uncertainty: Businesses must continue to make supply decisions in the short- and medium-term even though the value of that production will depend on changes (possibly large) in the exchange rate and other economic and political factors. In this type of environment, firms tend to be more cautious and often reduce investment until there is more certainty in the market. If both consumers and firms react to uncertainty by pulling back consumption and investment expenditures, then the result will be slower economic growth.
Finally, we can think about at least one aspect of the effects of the Brexit vote on the Texas economy. As implied above, a firm that sells goods in the United States but books the profits in the UK would benefit from the lower exchange rate. For example, a profit of 100 U.S. dollars would be equivalent to 67 pounds with an exchange rate of 1.5 pounds to a dollar. If the exchange rate falls to 1.3, then a 100 profit in U.S. dollars is equivalent to 77 pounds. Thus, British firms operating in Texas that sell in markets other than the UK would gain from the decline in the pound; however, that may be offset by other economic effects, such as a general decline in economic activity. But this is important, as Texas ranks third (behind California and New York) in foreign direct investment (FDI) in the United States. In addition, the UK is the largest source of FDI in the Texas economy at about 22 percent, with the bulk being in the energy industry. The Texas Comptroller reported that in 2013, more than 204 UK companies operated in Texas. The comptroller also reported that UK investments supported almost 90,000 jobs in 2011. Fortunately, these companies may benefit from the decline in the exchange rate. But for U.S. firms located in the UK, the opposite result will hold, as profits in the UK will be less valuable in the United States. In addition, since much of the FDI is in the energy sector in Texas, if the vote leads to a general economic slowdown, energy prices — and thus Texas — could be negatively affected.
To sum up, there is a tremendous amount of uncertainty surrounding the political and economic outcomes of the Brexit vote. As we learn more about the process of the UK exiting the EU and the related political outcomes, we should be able to get a better grasp on the long-term economic effects. But for now, we should expect increased volatility as market participants gather and interpret new information.
John W. Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute and an adjunct professor of economics at Rice University.