After an emotional weekend following Brexit, thousands of financial analysts around the world spun their wheels trying to predict the consequences of Brexit. There was consensus that both the UK and EU will end up as losers, but most predict that the current financial system can take the shock and engineer the transition to a new, albeit lower, equilibrium. However, few financial analysts or economists look at the possibility of a second shock, and even fewer dare to predict an Armageddon type of unravelling of events that will plunge the world into crisis.
Most analysts looked back at the 1998 Asian crisis, the 2008 Global Financial Crisis (GFC), and the 2011 Greek crisis. They pointed out that the market will soon forget the episode and bounce back later, like previous crises. Although such optimism is well-founded and echoes the human behavior of anchoring their future expectations on past experience, I am afraid that Brexit will be different.
The most basic difference between the past major financial crises and the present one is the casual factor and resolution mechanisms. Though everyone agrees on the interdependence of political institutions and the economy, there will always be a difference in their relative importance in triggering an economic event and roles in resolution. In the 1997 Asian crisis, 2008 GFC and 2011 Greek crisis, the main causal factors were financial sector-induced economic breakdowns. All three crises were resolved by strong political institutions. In the 1997 Asian crisis, the IMF led the refinancing rescue of Asian countries, and no matter how controversial the measures were on hindsight, the crisis was resolved in a few years. In the 2008 GFC, the G20-initiated global central bank coordination with loose monetary policy, and the subsequent Quantitative Easing stabilized the frozen credit market and the economy. In the 2011 Greek crisis, the EU and ECB led the rescue effort to provide a lifeline to Greece and preserve the EU, while people complained that the Greek resolution was a “kicking the can down the road” exercise. From these crises, we learn that the return to normalcy based on politically-motivated economic decisions does buy tranquillity and time to work out an ultimate solution.
In recent years, political institutions have been active in resolving economic crises. However, in the current Brexit, the situation is different. In Brexit, the political institutions of UK and EU are precisely the ones caught in the middle of the crisis, and there seems to be little recent historical precedence on how to resolve the looming economic and financial ramifications. On top of that, the timeline on working out the problem is much more compressed.
Both the UK and EU face existential challenges at this moment and a slight misjudgement on either side can trigger a secondary shockwave that is much more severe than the initial June 23 shockwave. The likely pro-Brexit new UK administration will try to extract the best exit terms and show the population that they can still enjoy the benefits of free trade with the EU sans the cumbersome and unpopular Brussels link. If they get an inferior deal, then the chance of Scotland and Northern Ireland seceding from the United Kingdom is very real, while for the EU, too lenient an exit deal with the UK will convince ultra-nationalist in the 27 remaining EU countries to copy the UK referendum — get out of the EU and enjoy the benefits of a looser tie. Of course, a harsh deal for the UK will simply encourage Scotland and Northern Ireland to break away from her, a move not detrimental to the EU but devastating to the country. In view of the difficulty of getting a win-win solution, one side must swallow its pride more than the other to get things amicably done. The real issue today is which side has the stronger and wiser leader who is willing to compromise.
It is a difficult situation for both the EU and UK. Achieving a win-win solution is almost impossible and the best solution is to accept a compromise in the exit negotiation. Most analysts have overlooked that the real challenge ahead is the exit negotiation. Brexit has opened Pandora’s box and strong leadership from both the UK and EU is needed to prevent further emotion-driven populism from hijacking the more important issue of amicable separation. In a way, both the UK and EU leadership are against the wall. We just hope their wisdom and courage can steer the world from the dreadful secondary shockwave.