Brexit is not a major global shock

It rarely happens, but sometimes Scott Sumner and I disagree and that is the case presently.

Scott sees Brexit as a major negative global shock, while I think that Brexit on its own is not really a big deal.

The paradox is that going into the latest political and market events Scott has actually been rather relaxed about both the global economy and the US economy, while I have been a lot more worried.

I have been worried that premature monetary tightening could send the US economy into recession and could blow the ‘dollar block’ up and in the process cause a major Chinese crisis and at the same time I have in the latest couple of months also started to worry that slowing nominal GDP growth in the euro zone could cause another ‘euro spasm’.

I very much worry about these issues and therefore I am hardly think that the Brexit vote is doing much to help things and I personally am deeply worried and frustrated that this might to a very large extent be yet another example of increased nationalism and anti-immigrant populism across Europe, the UK and the US.

But Brexit in my view is just yet another factor that could further deepen the crisis – and I have discussed the mechanics of it in my previous post – but on its own I don’t think this is a major negative shock to the global economy. It can develop into a very bad shock if monetary policy once again fails, but from what we have seen so far in the financial markets the shock is not particularly big.

Yes, it is correct that we saw some rather dramatic market action on Friday and Monday, but if we look at the market action over the past week or over the past month there is nothing particularly alarming about it.

Let me try to illustrate it by looking at a couple of markets. Lets start out with the dollar. This is weekly changes in EUR/USD since the beginning of 2015.


The Brexit ‘shock’ is the very last down move in EUR/USD (a stronger dollar). This is consistent with what we would normally seen when we have a spike in risk aversion in the markets – the dollar as the main reserve currency of the world strengthens.

Hence, we see the dollar has strengthened over the past week, but it is barely more than one standard deviation (from 2008 until today) and there has been numerous weekly moves in the dollar just since 2015 that have been significantly larger particularly during 2015.

The story is more or less the same if we look at the global stock markets. This is weekly changes in the MSCI World Index of global stocks.

 MSCI World Brexit.jpg

Here the drop is slightly bigger than one standard deviation, but the drop in global stocks is not bigger than what we saw during a couple of weeks in January and February and significantly smaller than what we saw last year.

This is of course only two examples, but there are other s- for example the implied volatility in the US stock market (VIX) or the change in inflation expectations (they are down in the US and the euro zone, but not a lot and actually up in the UK and Japan).

Of course Brexit matters, but there are a lot more important things that should worry us more

My point is not that Brexit does not matter. It certainly does in all kinds of ways and it could end up being a horrible thing, but it might also – in a dream scenario – end up being a positive thing (the EU establishment will understand the message and reform and UK might not turn crazy anti-immigrant).

The markets are assessing these risks and judging from that the global financial markets are telling us that Brexit in itself is not a major negative event for the global economy and even though I am sad to see the UK (potentially) leave the EU I would agree with the market – Brexit is not the end of the world.

That, however, does not mean that I am particularly optimistic about the global economy at the moment. Hence, I continue to think that the Fed has been way too aggressive in terms of rate hikes and I fear that the Fed does still not understand that there is a significant risk of an US recession in the near future (even disregarding any effects from Brexit) and similarly and I am deeply concerned that we soon could have another “euro spasm” as a consequence of slowing nominal GDP growth and finally it is far too early to say that things are all well in China.

On a positive note Brexit might be the “excuse” both the ECB and the Federal Reserve need to reverse course and in the case of Fed cut rates rather than hiking.

In fact this is what the markets already are pricing in. And that should be remembered – because that is now the benchmark by which we should judge the Fed. Hence, if Yellen does not soon spell out that rates are more likely to be cut than being hiked then the risk of more market turmoil clearly increases.

Hence, maybe the real story is not whether Boris Johnson will become British Prime Minister or whether Jean-Claude Juncker learns to behave himself, but rather the question is whether the ECB and the Fed finally will get their act together and ensure a re-anchoring of inflation expectations. I am not too optimistic on that part.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail:





Brexit: Regime Uncertainty at the Zero Lower Bound

Brexit is on everybody’s mind and even before the – for the markets – surprising “Leave” vote on Thursday the British EU referendum was the dominating theme in the markets for awhile. When the news came out early Friday morning, the global financial markets reacted strongly.

That is the kind of reaction we are used to when we have a major “risk off” shock – stock markets drop sharply, the yield curve flattens, market inflation expectations drop, the pound weakens significantly and the dollar strengthens.

However, the question is what kind of shock it really is. The answer is that the Brexit shock initially is a supply shock that turns into a demand shock. I will try to explain that in this post.

Increased “regime uncertainty” is initially a supply shock

 The fact that the Brits voted to leave the EU in my view best can be described as what Robert Higgs called “regime uncertainty”. A shock that increases regime uncertainty is essentially a shock that increases uncertainty about the overall institutional framework in the economy – in this case: Will the UK be a member of the EU’s single market in the future? What will Brexit mean to the free movement of labour in Europe? Will UK banks be able to operate freely as before in other EU countries etc.?

This is the regime uncertainty regarding the UK economy, but equally, we have increased regime uncertainty within the EU. Will this for example lead to other countries leaving? Will this cause the “new” to drift in a more interventionist direction? Will this make it harder to get reforms through?

Essentially such regime uncertainty is a negative supply shock that should cause real GDP (growth) to drop in both the EU and the UK and cause an increase in inflation.

This in itself is bad enough but the historical experience shows that such shocks rarely have major impact and are of a relatively short-lived character and most observers of the situation likely would also agree that the EU and the UK will have a common interest in finding a solution that overall keeps the UK as part of the EU’s single market and realistically then it would not be unreasonable to assume that the overall level of tariffs and trade barriers in the UK and the EU will not be much changed in 5-10 years time.

So yes, Brexit has increased regime uncertainty, but on its own it shouldn’t be a matter that significantly should change the medium-term outlook for the EU and the UK economies.

The monetary shock is the most important shock

So while we have seen an increase in regime uncertainty, I believe a more important factor is what is happening to monetary conditions as a second order effect of the increase in regime uncertainty.

First of all, it is clear that Brexit has caused an increase in particular demand for US dollar and other safe assets. This is essentially a precautionary increase in money demand and for a given money base this a passive tightening of monetary conditions.

Secondly in my view, more importantly, the increase in regime uncertainty should basically be seen as a drop in the expected trend growth rate in both the UK and the euro zone. This means that we should expect the natural interest rate to drop both in the UK and in the euro zone and maybe even globally.

Given that both the Bank of England, the ECB and the Federal Reserve are targeting interest rates (using them as a policy instrument rather than using the money base) and that all three central banks have interest rates close to the Zero Lower Bound (ZLB) a drop in the natural interest rate (caused by a negative supply shock) will cause an increase in the difference between the policy rate(s) and the natural interest rate(s), which effectively is a tightening of monetary conditions.

This would not be a problem if interest rates where significantly above the ZLB as markets then just would expect central banks to cut rates. Similarly, it wouldn’t be a problem – even at the ZLB – if central banks were using the money base as a policy instrument as that would mean the central bank always would be able to ease monetary policy.

Unfortunately, both the ECB and the Federal Reserve do not seem overly eager to re-start/step up quantitative easing. As such, they have mentally committed themselves to a “liquidity trap”, which means that negative supply shocks automatically also turn into negative demand shocks.

It wouldn’t have to be this way and the Bank of England, which the markets clear perceive to be more willing to step up quantitative easing if necessary, in fact provides a good example of this. Hence, while inflation expectations have dropped both in the euro zone and the US, the opposite is the case in the UK where inflation expectations actually has to increase – and has been more or less flat over the past month. This clearly indicates that the markets expect the BoE to try to offset the negative shock from Brexit by easing monetary conditions. This by the way also give some reason to be optimistic about the macroeconomic impact of Brexit even in the near term.


In this regard, it is also notable that we have seen a sharper increase in the Credit Default Swap (CDS) on Italy than on the UK CDS on the back of Brexit. Said in another way, Brexit is hitting the euro zone harder than the UK.

Why is that? To me, the difference is that the UK has a floating exchange rate and a central bank willing to offset negative shocks, while Italy or other euro zone countries do not have an independent monetary policy to offset the shock from Brexit and the ECB likely also is less willing to ease monetary policy than the Bank of England is.

So once again – blame the ECB

 Yes, I know – it is Lars’ Law: Always blame the ECB. But I can’t help myself. It is clear to me that had the ECB been committed to at least hitting its inflation target and the markets had seen this target as credible, supply shock in the form of increased regime uncertainty would have had a much smaller negative impact than presently seems to be the case.

It is the failure of not only the ECB, but also of the Federal Reserve to ensure nominal stability and well-anchored inflation expectations that is magnifying this crisis.

There are worse things than Brexit

 Finally, I would like to note that even though distress has increased in the global financial markets since Thursday, there is no reason to panic over this “event” on its own. Had we had credible inflation targeting or even better, nominal GDP targeting central banks in Europe and the US then this would not be a big deal even for the global economy.

In fact, even taking into account the lack of credibility of the Fed and the ECB the market reaction might not have been quite a big as some (like my friends Scott Sumner and David Beckworth) seem to believe. Hence, if we look at for example the global stock markets they are little changes over the past 1-2 weeks. The same goes for the dollar and the global commodity markets. And most importantly, even though the shock has caused inflation expectations to drop – the drop has not in anyway been major.

Therefore, I actually believe that the focus should not really be on Brexit in itself. Rather I think it is much more worrying that the Federal Reserve has been overly eager to hike interest rates and as a consequence US inflation expectations have continued to decline since 2014.

Obviously as I discussed above these issued are linked in the since that the continued de-anchoring of inflation expectations both in the US and the euro zone increase the risk that any shock will be significantly amplified by lack of monetary policy credibility.

Therefore, it is of utmost importance that both the Fed and the ECB ensure nominal stability. That would mean a much stronger commitment to anchoring inflation expectations at 2% and a clear announcement that both central banks will increase money base growth if necessary to ensure their nominal targets. Unfortunately we have yet to see such commitment.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail:


Brexit: The Press Release the Fed should have put out

The Federal Reserve just released the following statement:

The Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union. The Federal Reserve is prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy.

That is all fine, but this is the statement the Fed really should have released instead:

“The members of the Federal Open Market Committee notes that the British people has voted to leave the European Union. The decision today has caused an increase in volatility in global financial markets and increased demand for safe assets including increased demand for the US dollar. This effectively is an unwarranted tightening of US monetary conditions.

While the Federal Reserve is not in the business of fine tuning neither the US economy nor the financial markets the Federal Open Market Committee nonetheless would like to remind market participants that the Federal Reserve has an 2% inflation. Expectations for Fed Fund rates should reflect this target and so should expectations for potential asset purchases.

Presently market inflation expectations on all relevant time horizons are below this target and the Federal Reserve therefore stand ready to take the appropriate action to ensure inflation expectations match the 2% inflation target. In this regard it should be noted that the Federal Reserve has the ability to increase the money base as much as necessary to hit this this target.

This means that the Federal Reserve remains committed to offsetting any internal and external shocks to nominal demand in the US economy that might jeopardize the inflation target. The Federal Open Market Committee will not allow inflation expectations to drift significantly away from the 2% inflation target.”

…Ideally it should of course say “4% Nominal GDP target” instead of “2% inflation target”, but for now lets just hope the Fed will take the 2% inflation target serious.

I will try to write more on Brexit in the coming days, which I essentially think is a “Remain Uncertainty”-shock (a supply shock) to the European economy that causes the “natural interest rates” to drop further below the the Zero Lower Bound. This in turns causes an tightening of monetary condition as the markets do not fully trust the ECB (and the Fed) to use to its ability to control the money base to offset this shock.

PS I think Scott Sumner is overestimating the scale of the “monetary shock” as a result of Brexit. Scott would realize this by looking at the change in the dollar, stock markets and inflation expectations over the past week instead of looking only at the market action today. The shocks related to a more hawkish Fed and toubles in China in August last year and in January-February this year were larger.

Beckworth talks to Hetzel

David Beckworth has a great interview with my friend and great hero Robert Hetzel. Listen here.

German 10-year yields just dropped below zero

Here we go…10-year government bond yields just dropped below zero.

Negative yields in Germany

Does that mean that euro monetary policy conditions are “ultra easy”? Nope certainly not – it is rather the opposite.

Lets once again quote from Milton Friedman’s 1998-article about Japan Reviving Japan:

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

The story is the same – monetary policy is TIGHT and is becoming tighter as the demand for money increases faster than the supply of money.

My talk with David Beckworth

I have had a good talk to David Beckworth. Listen to the podcast here.

F. A. Hayek on Brexit

I am in Munich today to do a presentation on Brexit at the European Institute COO-CFO Roundtable.

As I was leaving home this morning I brought along Hayek’s classic The Road to Serfdom. I realized it was at least two decades since I had read it (all) last time so I thought it could be interesting to read it again.

And since I am speaking about Brexit today I started with chapter 15 “The Prospects if International Order” and lo and behold I found this very interesting quote that seems highly relevant to the discussion of Brexit:

“The English people, for instance, perhaps even more than others, begin to realize what such schemes (LC: an international federation) mean only when it is presented to them that they might be a minority in the planning authority and that the main lines of the future economic development of Great Britain might be determined by a non-British majority. How many people in England would be prepared to submit to the decision of an international authority, however democratically constituted, which had power to decree that the development of the Spanish iron industry must have precedence over similar development in South Wales, that the optical industry had better be concentrated in Germany to the exclusion of Great Britain, or that only fully refined gasoline should be imported to Great Britain and all the industries connected with refining reserved for the producer countries?”

I think this pretty well captures the sentiment among the Brexit campaigners today, which is pretty incredible given Hayek wrote this in 1944. That said, that does not mean that Hayek would have favored Brexit. In fact in the same chapter Hayek makes the following statement:

It is worth recalling that the idea of the world at last finding peace through the absorption of the the separate states in large federated groups and ultimately perhaps in one single federation, far from being new, was indeed the ideal of almost all the liberal thinkers of the nineteenth century. From Tennyson, whose much-quoted vision of the “battle of the air” is followed by a vision of the federation of the people which will follow their last great fight, right down to the end of the century that final achievement of a federal organization remained the ever recurring hope of the next great step in the advance of civilization.

In fact in his 1938-article “The Economic Conditions of Inter-State Federalism” Hayekmakes an argument for Federalism (even arguing for some kind of monetary union !), which surely could give some ammunition for the “remain” campaign.

And this pretty well sums up the dilemma for the classical liberal in the discussion over Brexit. There are classical liberal arguments both in favour and in against Brexit.

PS Listen to Tyler Cowen talk about “The Economic Conditions of Inter-State Federalism” here.

PPS The example of a Hayekian “remainer” in my view is the Dalibor Rohac, who in his new book “Towards An Imperfect Union – A Conservative Case for the EU” makes a strong Hayekian case for the EU.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or myself at lc@mamoadvisory.

Why the US labour market is softening – the one graph version

Friday’s US labour market report was a huge disappointment. This graph explains why.

Muscial Chairs model

This is of course Scott Sumner’s Musical Chairs model of the US labour markets. Simply said the model predicts unemployment to rise if demand growth (nominal GDP) slows relative to the growth of labour costs (average hourly earnings).

With monetary conditions tightening (NGDP growth slowing) and minimum wage hikes helping push up wage growth it should hardly be surprising that we are now seeing a softening of US labour market conditions.

It is not dramatic, but there can be little doubt about the trend and it is essentially the same kind of policy mistakes that we saw in the 1930s – too tight monetary policy combined with labour regulation that push up wage growth. Scott of course documents this very well in his new book the Midas Paradox

Larry White will visit Copenhagen soon (Hurray!)

One of the greatest living monetary historians professor Larry White will be visiting Copenhagen in less than two weeks.

I am personally a huge fan of Larry and his work – particularly his work on the history of Free Banking, but for those of my readers who for some odd reason do not know Larry then here is his bio (stolen from Cato Institute):

Lawrence H. White is a senior fellow at the Cato Institute, and professor of economics at George Mason University since 2009. An expert on banking and monetary policy, he is the author of The Clash of Economic Ideas (Cambridge University Press, 2012), The Theory of Monetary Institutions (Basil Blackwell, 1999), Free Banking in Britain (2nd ed., Institute of Economic Affairs, 1995), and Competition and Currency (NYU Press, 1989). He is co-editor of Renewing the Search for a Monetary Constitution (Cato Institute, forthcoming), and editor of The History of Gold and Silver (3 vols., Pickering and Chatto, 2000), Free Banking (3 vols., Edward Elgar, 1993), and The Crisis in American Banking (NYU Press, 1993). His articles on monetary theory and banking history have appeared in the American Economic Review,Journal of Money, Credit, and Banking, and other leading professional journals.

White received the 2008 Distinguished Scholar Award of the Association for Private Enterprise Education. He has been a visiting research fellow at the American Institute for Economic Research, a visiting lecturer at the Swiss National Bank, and a visiting scholar at the Federal Reserve Bank of Atlanta.  He is a co-editor of the online journal Econ Journal Watch, and hosts bimonthly podcasts for EJW Audio. He is and a member of the Financial Markets Working Group of the Mercatus Center at George Mason University.  He currently blogs at

White holds a BA in economics from Harvard College and a PhD in economics from UCLA.

Other than his work on Free Banking Larry has written a fantastic book on the history of economic thinking. The Clash of Economic Ideas ,which was published in 2012 is one of the best books on economics I have read in the last couple of years and is highly recommend.

So I am very happy that we are getting Larry to Copenhagen very soon. He will be speaking at two events in Copenhagen. One at the CEPOS think tank (see here) and one event at the University of Copenhagen (See here).

I am personally particularly looking forward to his lecture at the University of Copenhagen on June 14.

The title of the lecture is “The History of Free Banking and the Gold Standard, and their Relevance for the Future”. I highly recommend any with interest in monetary theory, policy and history to participate in this seminar.

For more information regarding the seminars please contact Head of Research at CEPOS Otto Brøns-Petersen or me (lc@mamoadvisory).


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