Jun

6

 "The economic consequences of a Donald Trump win would be severe"

by Lawrence Summers

On June 23, the UK will vote on whether to remain in the EU. On November 8, the US will vote on whether to elect Donald Trump as president. These elections have much in common. Both could lead to outcomes that would have seemed inconceivable not long ago. Both pit angry populists against the political establishment. And in both cases, polling suggests that the outcome is in doubt, with prediction markets suggesting a probability of between one in four and one in three of the radical outcome occurring. It is interesting to contrast the way that financial markets are reacting to these uncertainties. The markets are highly sensitive to Brexit news: the pound and the British stock market move with every new opinion poll. Analysis of option pricing suggests that if Britain votes to leave the EU, sterling could easily fall by more than 10 per cent and the British stock market by almost as much. It is widely believed that the uncertainties associated with Brexit are consequential enough to affect the policies of the US Federal Reserve and other major central banks.

It would in all likelihood be economically very costly for Britain to leave the EU and would raise questions about the future cohesion of the UK. It would also threaten London's role as a financial centre and curtail British exports to Europe.

What I find surprising is that US and global markets and financial policymakers seem much less sensitive to "Trump risk" than they are to "Brexit risk". Options markets suggest only modestly elevated volatility in the period leading up to the presidential election. While every Fed watcher comments on the implications of Brexit for the central bank, few, if any, comment on the possible consequences of a victory for Mr Trump in November.

Yet, as great as the risks of Brexit are to the British economy, I believe the risks to the US and global economies of Mr Trump's election as president are far greater. If he is elected, I would expect a protracted recession to begin within 18 months. The damage would be felt far beyond the United States. First, there is a substantial risk of highly erratic policy. Mr Trump has raised the possibility of more than $10tn in tax cuts, which would threaten US fiscal stability. He has also raised the possibility of the US restructuring its debt in the manner of a failed real estate developer. Perhaps this is just campaign rhetoric. But historical research suggests that presidents tend to carry out their major campaign promises. The shadow boxing over raising the debt limit in 2011 (where all participants recognised the danger of default) was central to the stock market falling by 17 per cent.

Ralph Vince writes:

What is not addressed is the question of what would be the economic consequences (and contrary to Dr. Summers musings, let;s keep it something measurable, like GDP growth) of another negative 100-500bln/yr in further deteriorated balance of trade over the next several years?

Are we willing to suffer another 2.5-3% drag on YoY GDP growth?

John Floyd writes: 

Yes, as with another winner of the John Bates Clark award in the year prior the reasoning leaves much out and is ingrained in a certain hue. Nonetheless I find the tack interesting as we approach UK referendum, FOMC, US elections, Italian referendum, etc. in the coming months and the potential impact and opportunities in markets. Not quite up to Patton's statement to Rommel, but along the same battle lines.

Ralph Vince replies:

Agreed.

This is a period that is a serious test of traders and nerves now, more so than the usual, more than the past four or five hours at the bridge table. With this hand, it gets particularly interesting now, for those who haven;t dozed off and know what the t the contract is now.

anonymous writes: 

As an extension to this line consider that one of the key tools in forecasting Bernanke’s reaction post 2008 was knowing his previous writings and statements as well as direct words including something very close to “a Japan type situation will never happen on my watch”.  To that line of reasoning consider and read Yellen’s work at SF Fed on the US economy and the influence of housing, etc. and I think that is a good roadmap to her speech today and actions coming in the future.


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