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A WAKE-UP CALL FOR THE EU

John Gorlow | Jun 24, 2016
 What a difference a day makes. 
 
“Explosive shock” is how one Reuters headline described the reaction to yesterday’s vote that severed UK ties with the European Union. Markets around the world plunged as analysts and pundits struggled to understand long-term implications. Investors were stunned, wondering where the unraveling of the EU will end. 
 
In retrospect, maybe the world should have seen it coming. The UK’s departure from the EU is the result of long-simmering frustration with the collapse of the UK manufacturing sector, stagnant growth, a bungled and inefficient response to an immigration crisis, and the slow but steady rise of a populist movement that blames these problems on government. Throw in a a few southern European countries  drowning in debt, and it’s easy to see why many people want no part of it. When the government—the EU government in this case—is portrayed as aloof and out of touch, the stage is set for revolt. That is Brexit in a nutshell. 
 
Can EU troubles be resolved? Let’s hear what two economists think. 
 
IT’S AN ECONOMIC PROBLEM
 
Holman Jenkins (WSJ, 22-June) writes, “What’s really eating the Western public is the lack of economic growth, the fear that social relations are unsustainable given towering debts, endless commitments to spend money that doesn’t exist, and inexorable armies of unemployed young people and migrants.” As governments pay their bills by “printing money,” he argues that inflation is inevitable and Western governments will be unable to support burgeoning health care and pension benefits. There will be no alternative “except policies aimed at getting economic growth and productivity going again.” Thus far, the EU has failed to act collectively to stimulate growth and job creation. Perhaps that will change. 
 
IT’S A GOVERNING PROBLEM 
 
New York Times reporter Eduardo Porter (21-June) sees a failed governing body as the root of the problem. “European leaders must figure out how to overcome the narrow national interests and mistrust that tie it in knots every time a collective response is needed. That will require democracy on a European scale,” he writes. 
 
Like Jenkins, he points to the immense “frustration among the working class” and the “hapless response to their social and economic challenges” by European institutions. Meanwhile, the European integration effort “has lost sight of its political and social dimensions, narrowing into a raw effort to reduce market barriers.” What people want is to have a say over the politicians. “That’s called democracy,” he says.  Representation by government is a long-held tenet of democracy. Perhaps the UK vote is a warning to other governments to pay attention. 
 
A VOTE AGAINST PROSPERITY?
 
Calling Brexit a choice between “bad and worse,” Paul Krugman wrote last week that an exit vote would create a much poorer Britain… about “two percent poorer than it would otherwise be, essentially forever. That’s a big hit.” He also expressed concern that by undermining the financial capitol of London, “the costs could be substantially bigger.” Time will tell if these predictions are correct. 
 
What could cause more than 50% of voters to vote against their own economic interests? Like others, Krugman sees the failure of the EU to develop a collective vision. Discontent in the UK was stirred by job losses—up to 80% of manufacturing jobs have disappeared—along with cuts in social services and a general sense of backsliding. Meanwhile, British voters observed “Germany’s insistence on turning the crisis the single currency wrought into a morality play of sins (by other people, of course) that must be paid by crippling budget cuts.” 
 
WHAT TO DO NOW
 
Hindsight does little good at this point. The markets—and investors—lost billions of dollars today. The good news (if you can call it that) is that Krugman and others believe the Brexit vote is not likely to bloom into a full-blown financial crisis, and because the UK currency is not the Euro, monetary chaos is likely to be contained. Even so, the risks are unknown and future growth surely will be affected. 
 
Dimensional Funds today reminded investors that “We have seen markets increase discount rates in time of uncertainty before, resulting in lower prices and increased expected returns. However, it is difficult to know when good outcomes will materialize in the future….Many of those who exit the markets miss the recoveries.” 
 
Our advice is to be sure your asset allocation is aligned with long-term goals. Stay diversified. And don’t hesitate to call us if you have questions or concerns. Remember, the UK will have up to two years to negotiate a withdrawal from the EU and much can happen during that time. 
 
You’ll hear more about the economic impacts in our Q2 report, coming soon. In the meantime, hold steady.