Bank of England Governor Mark Carney was admirably quick to read the unfolding economic dangers of a Brexit when the referendum result was declared. While stock markets and sterling plummeted amid developing financial stress, the governor’s statement immediately brought to mind the famous “whatever it takes [to save the euro]” intervention by European Central Bank chief Mario Draghi at the height of the eurozone crisis in July 2012.
Carney started by making clear that the British banks are safe since their capital requirements are now ten times higher than before the 2008-2009 financial crisis. The purpose of these high requirements is to ensure banks will be able to pay off their depositors, which aims to reduce the risk of a banking panic.
Indeed, the UK banks have been stress-tested against more adverse scenarios than what the Treasury thought that Brexit might trigger. The scenarios included residential property prices falling by over 30% and the level of GDP falling by 4% at the same time as a 5% rise in unemployment.
The governor was obviously seeking to reassure the public that whatever the economic/financial headwinds after the Brexit vote, British banks are rock solid and won’t see a repeat of the queues outside Northern Rock branches nine years ago.
Carney was absolutely right to do this. Lack of confidence in domestic banks often triggers recessions as depositors withdraw money, which restrict the banks’ ability to lend and keep the economy growing. This can be particularly lethal when combined with capital flight, which is where nervous investors offload a country’s currency and assets priced in the currency for fear that it is falling in value.
In Britain’s case, there were reasons on the ground to justify the intervention. British customers have queued outside banks to ditch sterling in an attempt to “hedge” against Brexit. And the news of sterling dropping like a stone on the night of the count was a strong signal that investor confidence was deserting the UK.
The worries of these investors are well summed up by the IMF’s warnings over Brexit:
[It] could entail sharp drops in equity and house prices, increased borrowing costs for households and businesses, and even a sudden stop of investment inflows into key sectors such as commercial real estate and finance.
The UK’s record-high current account deficit and attendant reliance on external financing exacerbates these risks. Such market reactions could sharply contract economic activity, further depressing asset prices in a self-reinforcing cycle.
The liquidity weapon
As well as the reassurances about strong banks, Mark Carney also said the Bank of England is prepared to inject up to £250bn of liquidity for financial institutions to keep the economy going in these difficult times ahead. Without doubt, this is substantial financial help amounting to some two-thirds of the £375bn that the central bank has already pumped into the system in the form of quantitative easing in recent years.
Carney also referred to “extensive contingency planning” with Chancellor George Osborne throughout the night, as well as mentioning potential “additional measures” such as providing substantial liquidity in foreign currency if it was needed. That might desperately be needed by British companies trading internationally which might be exposed to large fluctuations in exchange rates because of turbulence with sterling.
Yet the governor deliberately didn’t spell out what any other measures might be. One option might be to cut the base rate down to zero or even charge banks for “parking” their cash with the Bank of England. The European Central Bank is already doing this to encourage European banks to continue lending to the private sector.
Carney was right not to reveal his full defensive armour yet. Suffice for the time being to let both the public and the markets know he has other policy weapons in place and is ready to be tested if the economic conditions make it necessary.
Cameron steps down
The governor’s speech came shortly after David Cameron resigned. The British prime minister was trying to show a very brave face by delaying his departure to October. This makes absolute economic and political sense because the captain of a sinking (UK) ship has a moral obligation to be the last one to abandon it.
Yet in truth, the eurosceptic Tories would hardly trust him to start the Brexit negotiations with the EU when he has fought passionately to stay in. He therefore might lose his job much earlier than he thinks. Not that this would have made any difference to the markets – his defeat made his departure unavoidable. The only thing that might have further traumatised the markets would have been if he had not resigned.
But despite Carney and Cameron’s efforts to steady the markets, they could do nothing to disguise the UK’s lack of preparation or plans for handling the Brexit negotiations. There are many possible options for trade deals with the EU but no clear direction.
The Brexit camp, particularly Justice Secretary Michael Gove, has attacked the economic “experts” who overwhelmingly warned of the huge economic and financial risks of such a move. They warned that four UK companies would lose out for every one that benefits from leaving the EU.
The odd argument of the Brexit camp is that these experts have to be wrong because they did not predict the 2008-09 financial crisis. “Once wrong, always wrong,” in other words. Now that Mark Carney has had to step in while the politicians try and work out what happens next, we will know pretty soon whether we economists are going to be wrong this time around. Don’t be surprised if we haven’t seen the last intervention from the Bank of England.