Paul Krugman on Brexit: Something to Agree With?

On June 23, 2016, U.K. voters shocked the world by voting for Britain's exit from the EU, or "Brexit," 52%-48%.  P.M. Theresa May hopes to invoke Article 50 and go for a hard Brexit shortly.  A majority of economists in both the U.S. and the U.K. (as well as most politicians, in fact), including the IMF and BlackRock, predicted an economic calamity if the withdrawal happened.  The pound would collapse, the Eurozone and especially the U.K. would fall into deep recession on par with the 2008 crisis, and there would be widespread economic and sociopolitical panic.

Four months later, the only real casualties are the reputations of such predictors of ruin.

Paul Krugman, a self-avowed Keynesian economist with strongly liberal political views, warned in advance that such predictions were unfounded.  In fact, he's one of the few who had asserted anything different from the mainstream story of a complete U.K. recession.  Despite being an opponent of the U.K. exit, Krugman urges economists to not let political opinions cloud their economic reasoning in "The Macroeconomics of Brexit: Motivated Reasoning?"

I'm not a huge fan of Krugman's economic beliefs and especially his political principles, but he is a brilliant award-winning economist who makes some insightful observations.  Krugman agrees with most economists when he asserts that U.K. trade will probably take a bit of a blow – most U.K. imports and exports are from the EU, so backing away from the Single Market would intuitively lead to some trade conflicts.  The U.K. would have to renegotiate extensive trade deals with most of the European countries.  In fact, even if the U.K. somehow ends up with a Norway-type agreement with the EU (Norway has rejected calls to be part of the EU; instead, it's part of the European Free Trade Association), firms would be less excited about investment because of the widespread uncertainty, and trade flows would be inhibited.  By reducing the I portion of Aggregate Demand, where GDP = C + I + G + (X-M), the real GDP would decrease (Figure 1.0).  I purposely made the shift to the left of the aggregate demand curve miniscule, as it is in fact not clear at all whether the uncertainty will impact business investment, or whether, indeed, it will affect it at all.


Figure 1.0 – Impact of Brexit on Investment and AD (S. Chan)

On the other hand, Krugman disagrees with many of his fellow economists, whom he accuses of "sloppy thinking."  Many are blind followers of "free trade," however accurate that term is, and expect that the slightly decreased long-term output of the U.K. as a result of Brexit would translate to an immediate massive recession, which has certainly not happened.  Krugman remarks that sometimes uncertainty will cause businesses to invest even more – in effect, to cover themselves for the future because of the uncertainty.  Because the pound would drop, it would be wise for businesses to invest as soon as possible so they could buy more foreign currency and resources with the same nominal amount.  There is uncertainty then, but uncertainty in and of itself may not create an aggregate demand shock.

Critics would argue that uncertainty – especially in a huge policy shift like Brexit – will induce shareholders to sell off stock and for businesses to save up for the unexpected along with decrease in consumer confidence, causing major loss in real GDP, but we haven't seen that happen so far.  British stocks are back to pre-Brexit level heights and are climbing (Figure 1.2).  In fact, the IMF (International Monetary Fund) itself has walked back its gloomy assessment of the U.K.'s economy and predicts a several-percentage-point increase in GDP next year – some of the biggest growth in developed nations.  This is because, when the uncertainty is resolved, we could have an explosion of investment as delayed investment decisions are made a few months later.  In addition, while consumer spending took a bit of a dip, they are back up to pre-Brexit levels.


Figure 1.1 – GBP vs USD: Not that big of a drop (Bloomberg Markets)


Figure 1.2 – British Stocks: Small dip, Massive recovery (Bloomberg)

However, possibly a side that many economists have not brought up is the fact that because the U.K. has a different currency from the Eurozone's, it is bringing the aggregate demand back to equilibrium.  When its currency is devalued (precisely due to the fact that it has a more flexible currency than the Eurozone), this could allow foreign countries to buy more U.K. products –  which are seen as cheaper, relative to pre-Brexit – causing the net exports of GDP to go up.  In effect, then, it is likely that aggregate demand will not shift much due to Brexit – any decreased investment will be counterbalanced by the drop in the pound, leading to greater net exports.  Monetary policy, then, can offset any decrease in aggregate demand.

Krugman argues that everybody will become so scared about the safety of their U.K. assets that the real value of the pound bounces low enough and expanding exports soak up all labor exiting from investment-goods industries, bringing it back to full employment (Figure 1.3).  In fact, the pound has not fallen anywhere near as far as consensus would have it (Figure 1.1).

The independent currency the U.K. possessed is precisely what gave it more incentive to leave the EU.  If the U.K. had the euro, we might run into major issues like what happened with Greece in that country's debt crisis.  With a semi-rigid currency, the U.K. would not be able to drive the pound down, allowing for greater investment at home to create more exports and hence greater aggregate demand.  In fact, probably a solution to some of Greece's problems would be to leave the euro immediately.  Sure, their currency would devalue, but it would fuel domestic investments and allow for a greater exports-minus-imports difference (yes, their trade balance is insanely negative).  That's a whole different essay.


Figure 1.3 – Possible Increase of AD due to Increase in X-M (S. Chan)

Granted, Brexit will cause some problems for aggregate demand as a whole, but this could be offset by another factor: diversification of the U.K. economy and a less stratified, more equal economy as whole.  As Krugman argues in another article, "Notes on Brexit," this weakening of the financial sector helps British manufacturing and industry.  Before Brexit, the U.K. was experiencing something called the "Dutch Disease" – essentially, when natural resource exports or financial exports crowd out manufacturing and boost up the currency.

By letting the currency drop, I suspect that while London's great financial section will take a hit, U.K. manufacturing will increase.  This in turn will cut into the trade deficit, which was draining blue-collar jobs that rely heavily on exports.  China's currency devaluation is part of the reason why its manufacturing is exponentially growing and its trade surplus is the highest in the world, resulting in some of the largest GDP growth.  Meanwhile, after the uncertainty from Brexit dies down, it's likely that financial firms that had fled to the Continent will return and reinvest.

The negative effects of Brexit have been overhyped and are, as Krugman points out, spurious.  The worst that can happen is a small percentage decrease in GDP in perpetuity and a reshuffling of the British economy.  The proof for the negative effects of even these events is not entirely conclusive.

Meanwhile, there are several notable benefits of leaving the European Union. Firstly, there is the freedom and liberation from an essentially unfree and undemocratic governmental body – the EU has become an elitist globalization advocate.  Britain leaving the EU would allow itself to re-establish national sovereignty, leaving out the possibility of another Greece problem.  In addition, the EU is failing fast – Britain's unemployment is one of the least in the EU at about 5%, matched only by Germany.  Norway, Iceland, and Switzerland are all out of the EU, and they maintain some of the lowest unemployment rates in Western developed nations (under 5%).  The U.K. still is in on the Commonwealth, which has been expanding rapidly compared to the sick, ailing EU, ahead in both growth and GDP (given that the U.K. drops out of the EU).

Given all this, I think the U.K. has been wise to leave when they could.  We'll see in the next couple of years whether France and Germany follow.

On June 23, 2016, U.K. voters shocked the world by voting for Britain's exit from the EU, or "Brexit," 52%-48%.  P.M. Theresa May hopes to invoke Article 50 and go for a hard Brexit shortly.  A majority of economists in both the U.S. and the U.K. (as well as most politicians, in fact), including the IMF and BlackRock, predicted an economic calamity if the withdrawal happened.  The pound would collapse, the Eurozone and especially the U.K. would fall into deep recession on par with the 2008 crisis, and there would be widespread economic and sociopolitical panic.

Four months later, the only real casualties are the reputations of such predictors of ruin.

Paul Krugman, a self-avowed Keynesian economist with strongly liberal political views, warned in advance that such predictions were unfounded.  In fact, he's one of the few who had asserted anything different from the mainstream story of a complete U.K. recession.  Despite being an opponent of the U.K. exit, Krugman urges economists to not let political opinions cloud their economic reasoning in "The Macroeconomics of Brexit: Motivated Reasoning?"

I'm not a huge fan of Krugman's economic beliefs and especially his political principles, but he is a brilliant award-winning economist who makes some insightful observations.  Krugman agrees with most economists when he asserts that U.K. trade will probably take a bit of a blow – most U.K. imports and exports are from the EU, so backing away from the Single Market would intuitively lead to some trade conflicts.  The U.K. would have to renegotiate extensive trade deals with most of the European countries.  In fact, even if the U.K. somehow ends up with a Norway-type agreement with the EU (Norway has rejected calls to be part of the EU; instead, it's part of the European Free Trade Association), firms would be less excited about investment because of the widespread uncertainty, and trade flows would be inhibited.  By reducing the I portion of Aggregate Demand, where GDP = C + I + G + (X-M), the real GDP would decrease (Figure 1.0).  I purposely made the shift to the left of the aggregate demand curve miniscule, as it is in fact not clear at all whether the uncertainty will impact business investment, or whether, indeed, it will affect it at all.


Figure 1.0 – Impact of Brexit on Investment and AD (S. Chan)

On the other hand, Krugman disagrees with many of his fellow economists, whom he accuses of "sloppy thinking."  Many are blind followers of "free trade," however accurate that term is, and expect that the slightly decreased long-term output of the U.K. as a result of Brexit would translate to an immediate massive recession, which has certainly not happened.  Krugman remarks that sometimes uncertainty will cause businesses to invest even more – in effect, to cover themselves for the future because of the uncertainty.  Because the pound would drop, it would be wise for businesses to invest as soon as possible so they could buy more foreign currency and resources with the same nominal amount.  There is uncertainty then, but uncertainty in and of itself may not create an aggregate demand shock.

Critics would argue that uncertainty – especially in a huge policy shift like Brexit – will induce shareholders to sell off stock and for businesses to save up for the unexpected along with decrease in consumer confidence, causing major loss in real GDP, but we haven't seen that happen so far.  British stocks are back to pre-Brexit level heights and are climbing (Figure 1.2).  In fact, the IMF (International Monetary Fund) itself has walked back its gloomy assessment of the U.K.'s economy and predicts a several-percentage-point increase in GDP next year – some of the biggest growth in developed nations.  This is because, when the uncertainty is resolved, we could have an explosion of investment as delayed investment decisions are made a few months later.  In addition, while consumer spending took a bit of a dip, they are back up to pre-Brexit levels.


Figure 1.1 – GBP vs USD: Not that big of a drop (Bloomberg Markets)


Figure 1.2 – British Stocks: Small dip, Massive recovery (Bloomberg)

However, possibly a side that many economists have not brought up is the fact that because the U.K. has a different currency from the Eurozone's, it is bringing the aggregate demand back to equilibrium.  When its currency is devalued (precisely due to the fact that it has a more flexible currency than the Eurozone), this could allow foreign countries to buy more U.K. products –  which are seen as cheaper, relative to pre-Brexit – causing the net exports of GDP to go up.  In effect, then, it is likely that aggregate demand will not shift much due to Brexit – any decreased investment will be counterbalanced by the drop in the pound, leading to greater net exports.  Monetary policy, then, can offset any decrease in aggregate demand.

Krugman argues that everybody will become so scared about the safety of their U.K. assets that the real value of the pound bounces low enough and expanding exports soak up all labor exiting from investment-goods industries, bringing it back to full employment (Figure 1.3).  In fact, the pound has not fallen anywhere near as far as consensus would have it (Figure 1.1).

The independent currency the U.K. possessed is precisely what gave it more incentive to leave the EU.  If the U.K. had the euro, we might run into major issues like what happened with Greece in that country's debt crisis.  With a semi-rigid currency, the U.K. would not be able to drive the pound down, allowing for greater investment at home to create more exports and hence greater aggregate demand.  In fact, probably a solution to some of Greece's problems would be to leave the euro immediately.  Sure, their currency would devalue, but it would fuel domestic investments and allow for a greater exports-minus-imports difference (yes, their trade balance is insanely negative).  That's a whole different essay.


Figure 1.3 – Possible Increase of AD due to Increase in X-M (S. Chan)

Granted, Brexit will cause some problems for aggregate demand as a whole, but this could be offset by another factor: diversification of the U.K. economy and a less stratified, more equal economy as whole.  As Krugman argues in another article, "Notes on Brexit," this weakening of the financial sector helps British manufacturing and industry.  Before Brexit, the U.K. was experiencing something called the "Dutch Disease" – essentially, when natural resource exports or financial exports crowd out manufacturing and boost up the currency.

By letting the currency drop, I suspect that while London's great financial section will take a hit, U.K. manufacturing will increase.  This in turn will cut into the trade deficit, which was draining blue-collar jobs that rely heavily on exports.  China's currency devaluation is part of the reason why its manufacturing is exponentially growing and its trade surplus is the highest in the world, resulting in some of the largest GDP growth.  Meanwhile, after the uncertainty from Brexit dies down, it's likely that financial firms that had fled to the Continent will return and reinvest.

The negative effects of Brexit have been overhyped and are, as Krugman points out, spurious.  The worst that can happen is a small percentage decrease in GDP in perpetuity and a reshuffling of the British economy.  The proof for the negative effects of even these events is not entirely conclusive.

Meanwhile, there are several notable benefits of leaving the European Union. Firstly, there is the freedom and liberation from an essentially unfree and undemocratic governmental body – the EU has become an elitist globalization advocate.  Britain leaving the EU would allow itself to re-establish national sovereignty, leaving out the possibility of another Greece problem.  In addition, the EU is failing fast – Britain's unemployment is one of the least in the EU at about 5%, matched only by Germany.  Norway, Iceland, and Switzerland are all out of the EU, and they maintain some of the lowest unemployment rates in Western developed nations (under 5%).  The U.K. still is in on the Commonwealth, which has been expanding rapidly compared to the sick, ailing EU, ahead in both growth and GDP (given that the U.K. drops out of the EU).

Given all this, I think the U.K. has been wise to leave when they could.  We'll see in the next couple of years whether France and Germany follow.