Brexit or Bust

As it happened, my wife and I were in Europe when the Brexit vote took place, and had several conversations with bemused Britons, Scots and Italians about the vote and its potential consequences. I was out of the office until July 5, so I missed the sharp market decline and equally sharp recovery, though I followed both the commentary and the market activity quite carefully.

The Economist, the English-speaking world’s most reliable source of utterly conventional wisdom, called the Brexit Leave vote “a senseless, self-inflicted blow.” Nigel Farage, head of Britain’s nationalist UKIP party, called it “a victory for ordinary people, for decent people.” Wealthy London, home to the UK’s powerful finance sector, voted to Remain, as did poorer, welfare-dependent Scotland. Most of the rest of the country voted to Leave.

The contrast says much of what one needs to know about the two closely-balanced factions throughout the West. Bureaucratic elites, finance types  and wards of the state versus strained working and middle classes struggling with a moribund global economy and stagnant wages.

The immediate consequences for the markets were negative. Worldwide, equity markets fell sharply, then rallied. For the second time this year, bears cried havoc and were proved wrong…or at least, premature.Markets dislike uncertainty, but amid record low interest rates on cash, stocks remain the preferred asset class. The dollar strengthened against both the pound (significantly) and the Euro (slightly).

A key investment principle is that disorder creates opportunity. The V-shaped market action (sudden fall, quick recovery) has been a pattern in recent years, as one market break after another has failed to transition into a true bear market. As usual, we took careful advantage of the market break to buy low in accounts with excess cash.

What will Brexit mean long term? That is very hard to predict. Protectionism weakens economic growth, but the UK leaving the EU does not necessarily mean adopting higher tariffs. All that must be negotiated.

Brexit is a very different proposition from Grexit. In the case of Greece, a net recipient of Eurozone transfers required immediate financial assistance in order to avoid defaulting on its obligations and possibly suffering a chaotic exit from the common currency. Brexit, on the other hand, contemplates one of the Eurozone’s wealthiest members, a net payer into the system, exiting the common market but not the common currency. (Britain never joined the Euro, keeping the pound.) Further, the Leave vote represents a mandate without a mechanism. There are provisions within the Lisbon agreement for member states to leave, but they have never been tested. Britain’s departure is likely to be a protracted process of negotiation and compromise. There could even be another vote repudiating the Leave vote.

We appear to be witnessing the end of the post-war project of economic and political integration in the Western democracies. That project paid great dividends, both in rising wealth and  (more important) in two generations of peace in Europe. (Or at least Europe’s core. The Balkans wars of the 1990s demonstrated the inability of united Europe to deal with even minor security issues, absent American leadership.)

Free trade and free markets create wealth, as Adam Smith argued centuries ago. But not everyone wins from globalization. In recent years, the economic benefits of a more-connected world have been concentrated in the hands of the finance sector and government. They have almost entirely bypassed the working and traditional middle classes. For those voters, Brexit was a rational rejection of the status quo.

Reducing regulation and bureaucracy, making markets more free and hence more dynamic and productive, could have widespread benefits. But higher growth would come at the cost of reducing both the power and the compensation of entrenched, unaccountable elites in both Europe and the United States. We’ll see whether those members of the New Class get the message.

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