Home > Uncategorized > How Britain’s Breakup With the E.U. Could Reshape World Markets

How Britain’s Breakup With the E.U. Could Reshape World Markets

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By PETER S. GOODMAN

JUNE 24, 2016

LONDON — First came the shock. Then fear seized world markets. As frenzied selling accelerated in Tokyo, Hong Kong and London, unfathomable amounts of wealth vanished in a matter of hours.

In crudest outlines, the panic that followed Britain’s vote to quit the European Union traced the 2008 collapse of Lehman Brothers, an event that turned an unfolding financial crisis into the bleakest economic downturn since the Great Depression. The similarities hung uneasily over markets on Friday, presenting a grim question: How ugly might things get?

As economists pored over the rout like accident investigators dispatched to the scene of a crash, most offered assurances that a Lehman-style financial panic was not unfolding. In that debacle, investors indiscriminately fled all assets connected to the disastrous American housing bubble. Mortgages had been carved into exotic investments and peddled around the globe, meaning they lurked everywhere. Distrust spread like a virus.

This time, the source of the trouble is both identifiable and relatively confined. Britain and the 27 remaining members of the European Union face significant uncertainty in their economic and financial dealings as they embark on complex divorce proceedings.

Fears that drawn-out negotiations could disrupt trade prompted investors to push their money toward safety. As night fell in London, the British pound was down more than 7 percent. Stock markets plummeted around the globe; the Standard & Poor’s 500-stock index closed down 3.6 percent in New York. London closed down a similar margin, and Tokyo surrendered more than 4 percent. Investors poured money into government bonds, seeking refuge.

“As of now, this doesn’t look like an end-of-the-world event,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics, an independent research organization. “It looks bad, but it’s not a cataclysmic game-changer similar to Lehman.” Then he paused. “Yet.”

In the best case, the plunge in markets represents an abrupt adjustment to the changing geography of global commerce. Britain has been diminished as a place for banking and business, and so the pound has lost some luster.

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In the worst case, investors have begun a fearful march away from risk, potentially starving emerging markets and stripping European countries of needed capital. It could last as long as the uncertainties dogging Europe — perhaps years.

If recent traumas have clarified anything, it is the tendency for trouble to emerge unexpectedly. The global financial system is so intertwined that links can remain opaque.

One key factor undergirds confidence that the so-called Brexit will not deliver Lehman-like troubles. In 2008, central banks on both sides of the Atlantic failed to recognize the mounting disaster. They failed to prepare adequate relief. While people may argue over the degree to which regulators have tamed the speculative excesses of finance, few dispute that improvements have been delivered.

“The financial systems in the U.S. and Europe, including the U.K., are far more capitalized and less leveraged than they were in 2008,” said Adam S. Posen, a former member of the rate-setting committee at the Bank of England and now president of the Peterson Institute for International Economics in Washington. “The proclivity to panic in ways that create financial instability are much more limited.”

The Bank of England and the European Central Bank have tools they can wield to defuse threats to banks. They can simply print money and lend it out as needed.

Less than an hour after markets opened in London on Friday, Britain’s central bank governor, Mark J. Carney, stood before television cameras and struck a resolute pose as he promised to do what it took to stabilize markets. He announced that he was prepared to unleash another £250 billion (about $370 billion) in pursuit of financial tranquillity.

“We expect institutions to draw on this funding if and when appropriate,” Mr. Carney said. “The bank will assess economic conditions and will consider any additional policy responses.”

Those words appeared to assuage fears, as the pound and stock prices both pared their losses.

In recent years, the Federal Reserve in the United States, the Bank of England and the European Central Bank have subjected financial institutions to so-called stress tests. They regularly scrutinize banks’ portfolios and the money they hold in reserve to make sure they can hold up in various outbreaks of trouble.

These tests have been welcomed by economists as a helpful addition to the warning system. Just this week, major American banks all gained passing grades.

Yet, these are academic exercises.

“This is the real stress test,” said Simon Johnson, a former chief economist at the International Monetary Fund and a professor at the MIT Sloan School of Management.

The immediate run on stocks and currencies might yet grow into something worse, shaking consumer confidence and prompting households to limit their spending. As businesses lose profit opportunities, they are likely to put off investing and hiring.

If that happens, it could create a spiral ending in recession, both in Britain and across Europe, adding to pressure on banks. The markets seemed to be warning of this possibility as they savaged the value of banking stocks on Friday.

The triumph of the Brexit campaign has also invigorated separatist inclinations elsewhere, in Scotland, the Netherlands and beyond.

The greater the odds that the European Union will splinter, the more investors are likely to demand extra payouts for fresh loans to debt-saturated countries like Greece, Italy and Portugal. That could squeeze businesses there, making it harder for them to borrow, further crimping their economies.

“That could then spread to the banks and go global, and that could smell like a Lehman,” said Markus Schomer, chief economist for PineBridge Investments, a global asset management firm. He put very low odds on this “referendum contagion” case.

If history is a guide, hedge funds, private equity and other realms of finance will also suffer. There, aggressive players borrow enormous sums of money to place outsize bets. Crises have previously revealed those taking on outsize risk. Long Term Capital Management, which borrowed heavily, appeared robust before losses in the Asian financial crisis of the late 1990s brought it to the verge of a collapse that threatened the broader financial system and required a private bailout.

As the prominent investor Warren E. Buffett once put it, “Only when the tide goes out do you discover who’s been swimming naked.”

Those who had been paying attention to the American housing crisis were hardly surprised when Lehman’s afflictions burst into public view. Lenders had been writing mortgages to seemingly anyone in possession of a signature. Lehman had been repackaging these loans and selling them for vast profits.

The surprise was that Lehman actually went bankrupt, exposing its trading partners to losses. By contrast, polls had suggested that Britain might really walk. This is a source of hope, given that central banks, governments and investors had more time to prepare.

“Lehman came out of the blue,” said John Van Reenen, director of the Center for Economic Performance at the London School of Economics. “This is like a train wreck where you can see the trains coming together for a long distance and you’re hoping the trains will swerve away.”

But any comfort in that is sapped by the fact that Britain, one of the oldest democracies on earth, put itself in this spot through an exercise of free will. Now, the world waits to see how far the pain spreads.

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