Brexit, the Pound, and the Euro

​Context
We all know: the UK (or “Britain”) exited the European Union. The consequences are deep and long term. An overview of the situation and what to expect going forward is in order. I wanted to wait for the dust and hype to settle at least a bit before writing about it. Be sure to read this post to the end!

The Basics
For those who are clueless, here are the very basics... Britain and most of Europe are in a Union that seeks to hamonize and facilitate trade, economic and financial cooperation, research efforts, labor mobility, and political unity. You don’t have to use the same currency to be part of such a Union, you just need to agree on rules of the game, standards of quality, safety, production, environmental regulation, etc. Companies and states can then “do business” across the area, knowing that things work in a relatively harmonized way. It’s a bit like a free trade agreement on steroids.
 
Most countries of the European Union have the Euro as their currency, but not all of them. For example Sweden, Denmark, and the UK do NOT use the Euro, but are in the EU. These countries have their own currency, their own central bank, and their own monetary policy, which is not the case of Euro members. There is a general expectation that EU members adopt the Euro some day. When a country drops the use of its own currency and adopts another one, it is quite serious and has very real consequences.
 
For instance, if the UK had decided to remain in the EU, it would eventually adopt the Euro and abandon the Pound. There are pros and cons to exiting the EU. Beyond the actual reasons for exiting and the debates over the fact that it was racism and populism in general that led to the exit, we can also simply ponder the long term consequences and look at the bigger picture.
 
Should I stay or should I leave?
Since I like to-the-point discussions, here are a few consequences that come to mind:

• UK immigration will now be entirely up to UK. If populist policies win, it may spell less population growth and lower economic growth. But that is a big “if”... It is not entirely clear that the UK will dramatically change the total volume of immigration in the long run, but it may decide to change the filtering process.

• Major financial institutions might want to be in the Euro Area and not London. This means the city of London will feel it quite a bit in the short run.

• Production and foreign direct investments by firms that wanted to be in a EU country will fall. Again it is not at all clear how large the impact will be in the long run. This may largely depend on the “breakup negociation” between the EU and the UK.

• Trade volume will probably fall, for 2 reasons. First, trade agreements must be renegociated, and that takes lots of time and can be a tedious and politically charged process. Second, firms that produce in one region and sell in another might decide to move operations entirely in the bigger market, which is the EU, and that means intra-branch trade might take a hit (intra-branch: trade of parts, services, etc within the same sector, with other companies, supply partners, or same-company branches in other countries).

 
Political and strategic considerations
Put yourself in the shoes of EU officials. EU unemployment is high. Many members are struggling with public debt, deflation, unemployment, and to top it all off, austerity and growing social discontent. Tensions are mounting in the more solid countries, where taxpayers are tired of feeling that their taxes are bailing out others. As an EU official, you don’t want this Brexit thing to spread and give ideas...
 
So you may have no choice but to make the UK “pay” for exiting. Not really out of childish frustration, but rather due to the strategic aspects: you need this to serve as an example. Exit, and it will hurt big time. That way you decrease the probability of other exits in the future and a further weakening of the EU and Euro Area.
 
The strategic aspects may force the EU to make it hard on the UK. What form does this take? Free mobility and passport privelege for UK residents in the EU. Tax advantages of UK residents working a lot in the EU and perhaps living there. Tariffs and all sorts of other trade barriers. WTO agreements and rules may pose an obstacle to excessive tariffs and trade retaliation, but the process can hurt quite a bit and the consequences could be serious.
 
The actual consequences of Brexit could theoretically be contained in the long run, even if the short run “transition” poses obvious complexities, challenges, and “trouble” for many individuals. The issue that may make it harder and more costly is the near unavoidable strategic aspects for EU officials to really drive the point home to serve as a lesson and protect the future of the Union: the Empire does not mess around with traitors. This is the real issue, and there is no denying that these policically strategic aspects are in the minds of EU officials.
 
What are the interests of big players like the USA and others in this mess? Well, all they want is financial and economic stability to avoid falling into another recession in a weak position, with zero interest rates and high government debt loads. So obviously status quo was the preferred option of all non-UK players.
 
The flavor of the month and the big picture
So the flavor of the month and year in markets is Brexit. It was the “China slowdown” in early 2016. It was Greece a few years back. Markets hop from fixation to fixation, with lots of hype-fed news and wild speculation about disaster scenarios.
 
Lets step back and look at the broader picture. The UK is an industrialized economy with free market policies, low unemployment, low inflation, an independant central bank and a long history of democracy, debate, and generally sound policies. It is part of a globalized world in which there are WTO rules that tend to encourage free trade. It has a highly functional monetary zone and economic setup, with very mature and developed financial markets and plenty of human capital. The UK will not totally fall apart after this. I don’t buy it.
 
Lots of people have put their own identities into this whole thing, causing emotional reactions and fear mongering. The reality is that although there are some elements of populism in the Brexit camp, leaving is not all loss in the long run...
 
Euro issues
Look at this table for a minute...​

Now it should be noted that the USA did indeed have a large drop in the participation rate and the employment rate, and that the unemployment rate at one specific time (now) does not necessarily represent the “general picture” of the situation. But actually, this table DOES represent how things have been for quite some time and does indeed represent relatively well a few key issues...
 
The Euro and the EU work for Germany. They don’t work as a general economic and monetary architecture. They don’t work for most of the other members, and they don’t fix the political tensions that they wanted to alleviate by this union.
 
The EU is essentially a free trade agreement like the North American Free Trade Agreement between the USA, Canada, and Mexico. It may be a special FTA, like “FTA on steroids”, but it is not that special, and it should not make members have to choose to drop their currency and adopt the Euro. Canada and Mexico do not have to drop their currencies and adopt the USD.
 
The Euro Area is built broken
Before 2008, the Euro Area was like an untested couple. Things were rosy and the “theoretical future” was full of hope and promise. The first real difficulties a couple faces are a test to the resilience of the union... Same for the EU and the Euro Area. The test was the global recession. How did this “union” deal with it compared to others? I will let you ponder this...
 
Since EU membership implies the eventual adoption of the Euro and pressure to comply to fiscal norms and other rules, lets discuss the Euro Area and the consequences of dropping a domestic currency.
 
A functional monetary zone has a few known characteristics, which we teach in International finance courses. They boil down to the capacity for the “monetary zone” to absorb shocks,  “economic and financial resilience” and a set of policies that tend to favor growth, prosperity, and jobs.
 
We could use any of the countries who have their own currencies as an example, but lets take my own country: Canada. The very same text could be applied to many other countries, such as the USA...
 
Here are a few traits of the Canadian Federation and its economic, financial, and social architecture:

1. ALL Canadians pay taxes in one form or another to the central government and have been doing so for a very long time and to a significant proportion of total taxes paid in Canada, and although some parts of the country sometimes complain about taxes and how some regions contribute more than others, there is no deep and serious questioning of this reality.
2. The central government provides transfer payments in many forms to ALL regions of Canada: i) old age public pension payments; ii) payments to families according to number of children; iii) grants and aid to students; iv) grants and aid to companies... and MANY others. I don’t want to debate about if Canada should be doing this or not – it’s not the point of the post.
3. Provinces (regions) of the Federation with weaker growth and standards of living automatically receive more aid from the rest of the Federation via Federal transfers to provincial governments. This helps to “put money on the words of the constitution” to favor equality of chance across the country, which is an important notion for most Canadians.
4. The central government provides public services to ALL Canadians and public spending on major infrastructure across the territory.
5. The unemployment insurance system (called Employment Insurance) is Federal: the risk of unemployment is insured by the entire Federation and the costs of unemployment are spread over the entire Federation. This is called “risk pooling” and is one of the basic principles of insurance.
6. There are Federal government bonds, which means that the central government can finance itself in markets by issuing Federal government bonds, which have top credit rating. It also means that, in an emergency, the central bank can even buy those bonds and nobody will freak out about it as long as inflation remains within the mandate of the central bank.
7. There is total labor mobility across regions, labor market structures are relatively similar, and the vast majority of Canadians speak and write English.
8. There are big Banks that have a presence on the entire Federation. This means that funds from one region with excess savings flow naturally to other regions via the integrated banking system.
9. Banking and financial regulation and oversight are highly harmonized and well-coordinated.
10. There is free trade and considerable economic integration.

 
In short, Canada has fiscal centralization, political unity, social acceptance that all regions participate in financing the Federation, total mobility. When a region gets more funding, it does not put into question the very existence of the Federation and it doesn’t even have to compress it’s spending or increase taxes. Actually, in general no one even talks about it. Provinces have considerable freedom, which allows for regional differences.
 
The whole setup means that Canada, like the USA and the UK, can absorb shocks to the entire region (recession) and also shocks that hit specific regions via automatic transfers and mechanisms that are “built in”... and this architecture doesn’t pose significant political issues and accusations. It “just happens” naturally due to the architecture of the Canadian Federation.
 
Now ponder the Euro Area while you go over these points. The Euro Area essentially has none of these elements. No automatic transfers, no central goverment or bonds, no political union that holds ground, no integrated banking, no social unity or common language, no pan-Euro unemployment system... No capacity to absorb economic and financial shocks. The country that plays the role of the central government is Germany: it borrows at low rates and extends loans to weaker countries, while tying the whole thing with strict conditions. It doesn’t work. The whole idea is beautiful and theoretically great, but it does not work for the majority of the population. Now maybe it will in a decade... or maybe things will just get worse due to eternal stagnation. Without prosperity, tension tends to increase quickly.
 
The Pound and the Euro
In the short run, the Pound will surely go through some hurting and volatility, but the bigger issues lie with the future of the Euro Area. When a setup works for only a select few while it creates a lot of trouble for others, an exit that weakens the EU poses an additional challenge to the single currency area. When you look at the cold facts, it is not clear which of the two loses more in the long run.
 
Adopting the Euro means that a country loses monetary independance and the exchange rate as a “buffer” to partially absorb shocks. In the case of the Euro Area, perhaps the UK would get the benefits like Germany does now, but do you want to be stuck in such a context with the long run future potentially plagued with political tensions between members, stagnation in other regions, and a potential for exits and defaults with catastrophic consequences? The risk may not be worth the marginal benefits.
Markets are currently pricing in monetary loosening from the Bank of England. Don’t short the GBP now based on that – it is all priced in. But we will see how far the monetary loosening will go, which could lead to multi-week depreciation if it becomes massive and if markets return to high alert mode. In general, this whole thing gives a bearish bias to the GBP and the Euro, and to their respective growth rates, with the UK feeling it more that the Euro Area.
 
The UK economy will eventually adjust, but without serious integration and reforms that move the Euro Area towards something that looks more like a functional monetary zone, the slow, grinding process of low growth and high unemployment, with one major player doing well will simply continue.

Concluding remarks
All people want status quo, because a Euro breakup is unthinkable, and that is probably true, at least for the foreable future. Is there a reasonable probability that all the Euro Area countries will really integrate to a point that they would form the “United States of Europe” like the USA or the Canadian Federation? I don’t know about you, but it seems VERY unlikely to me right now, especially with the social unrest and the spreading of “Euro Doubters” within EU countries. Since status quo is the only viable option for the EU and the global economy, the probable outcome is that the UK will feel the shock of the exit while EU officials use this as an example, but the bigger picture is actually scarier for the Euro Area...
 
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