06-27-2016, 02:22 AM
Larry Summers:
The situation of European banks should and will receive extensive policy attention. Even before the last 24 hours, several were selling at price-book value ratios suggesting alarm about their prospects. And some, not only British banks are now down more than 20 percent. Large flight to quality flows into the dollar and yen also risk bringing on alarm about emerging markets and a return to concern about currency wars.
For Britain, the economic effects are two sided. On the one hand, a major jolt has been delivered to confidence, to future unity and down the road to trade. On the other, the currency has become more competitive, and liquidity will be in very ample supply. I would expect that a significant deterioration in growth and a recession beginning in the next 12 months has to be a substantial risk though short of an odds on bet. As suggested by the fact that stock markets in Italy and Spain are down almost twice as much as in the UK, the prospects for Europe may in some ways be worse than for the UK. There is the real risk of “populist exit contagion” in a number of countries. A credit crunch is a serious risk. Unlike in Britain, the trade weighted exchange rate is unlikely to decline very much. The central bank has less room for incremental policy measures.
The effects on the rest of the world will depend heavily on psychology. I continue to be alarmed as I wrote in this space a few days ago that this unexpected outcome in the UK will raise the spectre of “Trump risk”. If the UK can vote for Brexit perhaps the U.S. can vote for Donald Trump. I fear this possibility will lead to a freezing up of spending decisions particularly on the part of internationally oriented businesses. The odds of U.S. recession beginning within the next 12 months are I think now in the 30 percent range. Also noteworthy is that an environment of increased risk aversion and flight to quality will complicate Japan’s problem of generating inflation, and China’s challenge of attaining currency stability.