Brexit: the consequences on lending
The British voted in favour of leaving the European Union at the end of last week. Whether the UK effectively leaves the EU and what sort of arrangement emerges is yet to be determined. What is certain is that the business world now finds itself in the most uncertain of political environments: no one knows what kind of ruleset is actually going to be put in place and how long this state of limbo will last.
The whole situation is likely to prove damaging for the UK economy as businesses freeze hiring and investments until they have a better understanding about the rules they’re going to have to comply with. Brexit is in effect a typical case of what Robert Higgs named ‘regime uncertainty’.
Higgs described how regulatory regime uncertainty considerably hampered private investments in the US in the 1930s, which in turn affected economic recovery. This period saw Hoover and then FDR’s New Deal make considerable changes to the US legal and regulatory frameworks. According to Higgs:
given the unparalleled outpouring of business-threatening laws, regulations, and court decisions, the oft-stated hostility of President Roosevelt and his lieutenants toward investors as a class, and the character of the antibusiness zealots who composed the strategists and administrators of the New Deal from 1935 to 1941, the political climate could hardly have failed to discourage some investors from making fresh long-term commitments … there exists a great deal of direct evidence that investors did feel extraordinarily uncertain about the future of the property-rights regime between 1935 and 1941. Historians have recorded countless statements by contemporaries to that effect; and the poll data presented earlier confirm that in the years just before the war most business executives expected substantial attenuations of private property rights ranging up to “complete economic dictatorship.
Seen in light of modern expectations framework, Higgs’ theory does make sense: businesses are unlikely to engage into activities whose legal treatment is uncertain. In one of my first ever posts I wrote that, given the uncertainty inherent to a productive process that takes time, a stable ruleset and predictable property rights treatments were fundamental features of intertemporal coordination between savers/investors and borrowers/entrepreneurs.
Stable rules provide a clear guide to entrepreneurs: constraints are known in advance allowing them to anticipate future demand and plan accordingly with the understanding that their investments are protected as long as they remain within legal boundaries. The Rule of Law – what Hayek described as a ‘meta-legal’ framework that spontaneously and progressively emerged, and which is mostly incarnated today by the Common Law – represents the most effective instance of stable rules. But even the less stable Civil Law – which is mainly comprised of what Hayek called ‘legislation’ – can represent a relatively effective legal framework as long as rules aren’t changed on a regular basis. Surprisingly however, the academic litterature on regime uncertainty remains rather thin.
Coincidentally, a paper published earlier this year by Bordo, Duca and Koch (Economic Policy Uncertainty and the Credit Channel: Aggregate and Bank Level U.S. Evidence Over Severa Decades, also available on NBER here) adds extra empirical evidence to Higgs’ original findings. Basing their research on a recently published ‘economic policy uncertainty index’ (EPU thereafter), and controlling for other macroeconomic indicators, they look at how regime uncertainty affects bank lending in the US between 1961 and 2014. Overall, they find that
policy uncertainty significantly slows U.S. bank credit growth, consistent with it having an effect on broad loan supply and demand. We find that lagged changes in the EPU index are negatively and significantly linked to the growth rate of bank lending both at the aggregate and cross-sectional levels.
They also find that this effect is more pronounced for larger, less well-capitalised banks, as well as banks holding smaller amounts of cash reserves, and that the effect is likely amplified in Europe*:
The results have several important implications. First, statistical evidence suggests that economic policy uncertainty has affected bank lending in the U.S., which other studies have found to have important effects on economic activity and which we also find. This could have implications for Europe, where the Baker-Bloom-Davis (BBD) index of economic policy uncertainty rose more than in the U.S. during the post-crisis slump and the economies are more bank dependent. More recently, the EPU index in Europe has not recovered as quickly as in the U.S., where the subsequent recovery in bank-lending growth has been stronger as has been the overall recovery in GDP growth.
Given that London represents a substantial share of Europe’s financial activity and is the main Euro clearing centre (a situation that the ECB has fought for years), the implications for a post-Brexit Europe are clear. Domestically, the demand and supply of loans in the UK are likely to remain subdued as long as the legal framework that will apply to British banks and corporations in the future is unknown. The uncertainty is also going to hurt foreign banks, which have large operations in London thanks to the UK’s ‘passporting’ rights (which allow financial firms based in the UK to offer services throughout the EU under single market rules). Many of those institutions are unsure whether to move operations to other EU jurisdictions as nobody knows if the UK will be able to retain single market access and Euro clearing. This paralyses business-making in a period of already heightened regulatory uncertainty.
Legal uncertainty affecting the financial sector is of the worst kind given its repercussions on economic activity. It is therefore unsurprising that, following the Brexit vote, stockmarkets in the EU have fallen more than those in the UK. The announcement even triggered the worst fall in EU banks’ share price in history.
Brexit will have repercussions on lending and investments both in the UK and in the EU as long as this state of uncertainty lasts. And it can even end up being more damaging for other EU countries, already suffering from low economic growth and constantly-changing banking regulation. Of course, politicians seem unaware of this issue: some of the top ‘Leave’ campaign leaders mentioned triggering the article 50 of the Lisbon Treaty (which brings about the departure of a member of the EU) only in… 2020.
Given that it takes two years of negotiation following the trigger for a country to be formally out of the union, and that undoing EU laws while negotiating new trade deals can last many more years, it is clear that those politicians are at best – some would say unsurprisingly – completely ignorant of the damages they are making. It took Greenland, which withdrew from the pre-EU in 1985, three years to negotiate the terms of its exit with the union at a time when EU laws were not as invasive as they are now. Good luck to Europeans.
*They also question the timing of the implementation of new harsh banking regulations (i.e. Basel 3) which may have delayed the post-crisis economic recovery in their view (a point I have made in a number of posts over the years).
PS: Bordo, Duca and Koch also provide further evidence of the 1990s deregulation myth: