I think there is a pretty simple story here. Brexit increases uncertainty, both in the mean-preserving sense, and in the “very bad outcomes are now more likely” sense, and that lowers investment. That in turns shifts back the aggregate demand and aggregate supply curves, and a recession may result. Less than a year ago, MIT economist Olivier Blanchard published a major paper on capital inflows being expansionary, and now of course we are seeing the reverse. Toss in some negative wealth effects for further transmission. I was at an event in The City a few days ago where the anecdotal data about postponed or cancelled deals seemed pretty overwhelming, and this is consistent with what one reads in the papers as well, not to mention with basic economic theory. It is true of course that we don’t know how large these effects will be, but the more purely British measures of equity value are still down quite a bit.
Krugman is usually an exponent of the “don’t make things too complicated” approach, but here in this blog post he wants to…make things too complicated:
Second, doesn’t this argument imply a later investment boom once the uncertainty is resolved in either direction? That is, once Prime Minster Farage and President Le Pen have engineered the demise of the EU, there’s no reason to wait, and all the pent-up investment comes roaring back, right? But I haven’t heard anyone arguing that the contractionary effect of Brexit will be followed by a compensating boom once things settle down.
Third, doesn’t this argument suggest essentially the same effects from any policy negotiation whose end result isn’t known? Why don’t we say that the possibilities of TPP or TTIP are contractionary, because firms have an incentive to postpone investment decisions until they know whether these agreements actually happen? Somehow, though I’ve never heard anyone argue for the depressing effects of pending trade liberalization.
It is true investment might bounce back if Brexit were essentially undone, but that is hardly an argument for Brexit. The UK economy is about 85 percent services, those are currently “passported” into the rest of the EU, and it is very very hard to negotiate a new free trade agreement for services in anything like a timely manner, even when passions are not inflamed and there are no considerations of punishing other possible EU-defecting countries. So if you read someone writing “…after Brexit, the UK will face an average tariff rate of only xxx…” that is a sign they are not thinking hard enough about how trade agreements for services really work.
(Note also the subtle point that when financial and business services are being sold, the difference between “FDI falling” and “trade and exports falling” is quite a subtle one. Most of all, the traders of these services are investing in ongoing relationships. The decline of trade and the decline of investment are two ways of talking about the same contractionary process, it is not as if FDI falls, the exchange rate falls, and then trade then rises to pick up the slack, at least not in the UK-EU context. What is happening is that a negative shock to both trade and investment is coming up front, and then the British pound falls; the second-order response to that currency decline won’t undo the initial problem.)
On whether the same macroeconomic logic applies to other trade agreements, many investors may be playing “wait and see” before doing more FDI in say Vietnam. But still the very prospect of TPP in the meantime should not be lowering the chance of such investment in Vietnam because TPP represents some chance of a positive-sum advance. The potential loser is more plausibly China, and one does read about this effect. Investors may be less likely to set up plants in China because they are waiting on news about the options in lower-cost Vietnam. Of course given the relative sizes of China and Vietnam, this is unlikely to be a very large effect, but it does exist and it is already discussed. In contrast to that example, the EU is by far the biggest trading and FDI partner for the United Kingdom, and the prospective trade change is negative-sum rather than positive-sum.
What is most striking about Krugman’s post is how many Krugmanisms are completely absent from it. I mean recent Krugmanisms, this isn’t some kind of 1990s nostalgia (not today at least). Here are a few Krugmanisms which appear to be missing in action:
1. The EU is quite indecisive, it just kicks the can down the road and doesn’t resolve much uncertainty. Why not expect the same when dealing with the uncertainty from Brexit?
2. Just apply the AD-AS model quite simply, and follow it where it leads you.
3. How about increasing returns to scale? A lot of the UK exports to the EU are finance and business services, both areas which are plausibly based on clustering and scale economies. An initial whack to a clustered IRS sector can have quite significant long-run consequences, even if some or maybe even all of the initial penalty is reversed. This is part of what Krugman won a Nobel Prize for, admittedly I am hearkening back to the 90s and indeed 80s here but Krugman has cited this argument many times much more recently. This is also another reason why higher trade won’t make up for the investment shortfall, because the investment shortfall stifles the prospects for future high value-added trade.
4. The gravity equation. The pound has depreciated, but the EU is the UK’s natural trading partner, for reasons of distance, and the UK is unlikely to make up the difference by exporting more to the rest of the world. Export adjustment from currency depreciation won’t in general neutralize the impact of investment-destroying and EU-trade-destroying policy changes.
5. What about the multiplier? Isn’t the multiplier HUUGE in economies at the zero bound? And isn’t that the UK? And Cameron already has announced, plausibly in my view, that the UK won’t be meeting its forthcoming revenue targets. Won’t that result in a form of additional austerity sooner or later? With yet further multiplier-based negative macroeconomic consequences?
Where is the multiplier? I want my Paul Krugman back!
Going broader lens here, and moving away from Krugman, what I notice is many of the less academic Keynesians becoming less and less comfortable making arguments about deficient or contracting investment. C + I + G + X is ever so slowly morphing into C + G + X, at least in popular discourse. That is odd, because Keynes himself was most concerned with the instability of investment. It seems that these days however to worry about investment is to sympathize with capitalists, and perhaps to even wish to keep more resources in their hands.
I want my investment back! It is no accident that Keynes’s solution was to nationalize investment, not to redistribute away from capital per se. But nationalizing investment isn’t very popular these days, and so the vitality of capitalism and capitalists once again becomes — or should become — an important issue.