Authors note—this was written on Saturday and Sunday (June 25^th and 26^th) . It takes a few days to get from the writing to publishing, as there are a number of approval steps required.  The message is still intact, and I think relevant, even if the markets rallied back a bit. TRH

In all the furor over the potential fallout from Brexit, there may be a few overlooked considerations.  The markets are clearly reacting negatively to the results of the referendum vote, but the actual economic effect of the vote is still far from certain, despite the vast amount of confident commentary on the subject.   Here are a few considerations for the sake of discussion:

First, Britain is only about 3.9% of world economic output, by measure of nominal Gross Domestic Product, which basically measures output—you can check that anywhere.  It is something around 3 Trillion of the world’s 73 trillion output as of 2014.  Check that out on Wikipedia if you want to see the list HERE.  That means it is closer to France, Brazil, Italy and India (2.8, 2.4, 2.1, and 2.0 Trillion respectively) than it is to the United States, China, or Japan.  

Let’s think about what this means.  Japan had a decade (or two) long economic train wreck starting in the 90’s from which they are still struggling to recover, and had a tsunami and a nuclear meltdown.  When that began Japan was a far closer second to the United States in output.  The whole world was flocking to their shores in order to learn how they managed their unparalleled growth.  Tokyo apartments the size of Cadbury crème eggs were selling for more than the Biltmore estate, and wealthy Japanese people were buying golf courses in the United States in order to have a place to go to unwind (Okay—I admit that these are exaggerations, but they are not as far off as you might think).  The world stood in awe at the engine of economic growth that was Japan at that time. 

Don’t get me wrong, Japan is fighting back.  I do not mean to disparage Japan, or their economy.  My point is that they were not a 3% player in the game.  No matter what happens next, whether the UK negotiates a complete exit, or does something like Norway, if they use Article 50 or they negotiate privately or fight it out in court…things look like they will be tough in the UK for the foreseeable future.  Analysts are all taking down their expectations for Britain’s economic growth, and some are taking the EU estimates down as well.  A sloppy consensus of this might be a loss 1% for the UK (down from 1.78%) and a half a percent loss for the EU, as a result of the uncertainty etc. 

Imagine that GDP Growth went negative by one percent, not the end of the world.  Even if the UK lost an entire percent of GDP A one percent loss of 3 Trillion is about 30 Billion dollars of economic loss to them.  Granted that is no fun for the UK, and probably not for the global economy either.   Now, I want to point out that this figure is a far cry from the massive recession that hit the world’s second largest economy about fifteen or so years back, when Japan tanked.  That cost about a trillion in output, in 1990s dollars, so call it twice that today.  Yet, the world survived it, and other people stole a march on Japan amidst the turmoil and emerged as economic players on the world stage.   I know that I keep using that example, and I am not trying to draw a parallel between the two situations which are quite different.  I am simply pointing out that the world economic system is big and complex.  The future is fundamentally unknowable, and many factors that will affect the future are not in anybody’s calculation.   In this hubbub, nobody noticed the gains that India is making, or Canada, who is just on the edge of this list.  China is rapidly cultivating a domestic economy (or trying to), and Brazil is working to pull out of a recession.  Japan is charging ahead with Abenomics, for good or ill.  Italy is struggling to reform its own byzantine system.  Any of these factors may be able to offset the really unfortunate situation that seems likely to be on the horizon for the UK. 

Why is the market taking this so badly? A lot of reasons, for sure.  It is unsettled by getting the referendum pretty far wrong.  In classical economics, by which much of the modeling of the world is done, with varying degrees of sophistication, it is generally accepted that actors (whether individual, company or state) act in their own informed self-interest.  Nobody really seemed to think that leaving the EU was in the UK’s “informed self-interest” and therefore everybody figured the vote would go the other way.  The market as a whole is therefore adjusting to a new worldview, and maybe doubting (and testing) some other assumptions.   For one thing, ten years from now, we might look back and decide they were right. 

First, I many market participants are wondering whether this referendum is an indicator of a tide of change in world sentiment, like an indicator of the emergence of populist movements toward isolationism and protectionism.  Maybe it is, but that is a very premature conclusion to reach from the available data in my opinion. For example,  Brexit and the Trump candidacy have been linked in the news, but really what relationship do those two things have?  Humans are connection machines.  We infer connections to make sense of the world.   It is how our brains work.  In today’s world, that is magnified by the amount of focus an issue has, and the availability heuristic.  The amount of coverage leads us to infer the amount of importance.  We cannot help it.  I don’t want to dismiss this as an important issue, but I feel comfortable that in the long run the world has weathered worse.  We survived two world wars,  and a nasty cold war, we can manage to have Britain go back to an independent sovereign nation outside of the EU, if that’s what they want.   Somebody out there will be glad they are doing it….

In case you aren’t tired of reading about it, we have posted or linked some commentary.  You can find it HERE and HERE and HERE.