There are two types of crash – and Brexit has caused both

Normally I steer clear of writing about the economy. But I’m making an exception this week because Brexit has messed everything right up.

On Friday, a video explaining the market’s reaction. On Monday: the most important thing to do. On Tuesday: opportunities in the mess.

Today I want to talk about the effect of Brexit on the overall economy. Now generally I steer clear of writing about the economy. I’m more interested in companies, products, businessmen, and opportunities.

But I’m making an exception this week because Brexit has messed everything right up. It’s not smart to take anything for granted any more. And you need to understand what’s going on in the world economy in order to invest sensibly.

The two types of crash

In order to make sense of what’s happening I have to explain the difference between two different types of economic shocks. Because the UK and, for example, Mexico, have been affected by Brexit in different ways.

So there are two types of crashes. They both have the same overall effect on the economy (i.e. they both cause recessions and lower living standards). But they have totally different causes.

The first type of crash is what’s called a real shock. A real shock, also known as a supply-side shock, means that the economy isn’t able to produce as much as it had been able to produce. These types of shock are relatively rare, because an economy’s productive capacity doesn’t often just disappear overnight.

But it does happen. If a natural disaster wipes out a factory, or OPEC suddenly raises the price of oil, or people are killed in a war, those are all real shocks. If 50,000 bankers have to leave the City of London due to Brexit – that’s a real shock. It basically means the country has less productive “stuff” than it had before.

The other type of negative economic shock is a monetary shock, also known as a demand-side shock. A monetary shock looks a lot like a real shock on the surface. It results in a recession and unemployment. But it has a completely different cause.

Instead of being caused by a “real” hit to the economy, like a factory getting burned down, a monetary shock happens when people stop spending money. When lots of people get frightened at the same time they want to hold cash, which is the safest asset. That increases the demand for money.

An increased demand for money has the same effect as a reduced supply of money. It slows the economy down. And if enough people do it, it crashes the economy. The Great Depression in the 1930s, Japan’s “lost decade” in the 1990s and the financial crisis in 2008 are examples of monetary shocks.

In contrast with a real shock, in a monetary shock there’s still the same amount of productive “stuff”. But when everyone gets fearful at the same time, the stuff goes unused, and there’s a big recession. As 2008 showed, monetary shocks can be very serious.

(If you want to see what I mean about 2008, take a look at my review of The Big Short.)

A real problem

Okay, that’s the dense part over with. I hope you’re still with me.

The reason I made the distinction between the two types of shock is that Brexit is hitting different economies in different ways. Some are facing real shocks, some are facing monetary shocks.

In the UK, Brexit is for the most part a real shock. London is the financial capital of Europe at the moment, and it’s very valuable to the UK economy. Big international banks like Citi, Deutsche, JP Morgan and Goldman Sachs base themselves in London so that they can sell all over the EU. Now that Britain’s out, there’s a good chance they won’t be able to sell into the EU any longer. They might have to move to new European bases in Frankfurt, Dublin or Amsterdam.

Also, around 3m UK workers are EU citizens. Some of them will have to go home. That’s another example of a real shock. Less productive stuff in the economy.

Real shocks are harder to fix than monetary shocks. There’s not a lot you can do about them. A real shock simply means that the economy is worse off than it was previously. And that’s where the UK stands at the moment. It’s hard to say how big a shock it’s going to be at the moment, because a lot depends on whether the banking industry stays put. But judging how UK based banks have performed this week, I’d be worried.

Curable

Brexit has rocked the rest of the world’s markets too. As I noted the other day, the Mexican peso was down 6%. The yen is up. The dollar is up against its trading partners.

Those are all live examples of the monetary shock. So, although bankers moving from London to Germany has nothing to do with Mexico’s economy, the peso dropped because investors are frightened, and they want to hold a safe asset – dollars.

The thing is that, unlike real shocks, monetary shocks can be solved fairly easily. They happen when there’s extra demand for base money. If the central demand creates base money, the system balances itself out, everyone chills out and the demand for money goes back to normal. Sometimes the central bank doesn’t even have to print money. If it tells everyone to relax, and everyone believes it, the system goes back to normal.

(I know this sounds implausible. But it happens all the time! A notable recent example is Mario Draghi cooling down the eurozone crisis in 2012 by pledging to do “whatever it takes” to save the currency.)

I hope the big central banks don’t make the same mistake they did in 2008. A monetary shock can cause a serious recession if central banks don’t react sharpish.

Dominoes

I’ve steered clear of Europe so far because it’s a special case. With Europe, the worry this that the UK is the first domino in a chain that leads to the breakup of the eurozone, or maybe even the EU.

In Italy Prime Minister Matteo Renzi has called a Cameron-style referendum on constitutional reforms. The reforms are all about making Italy’s government less dysfunctional. But he might lose the referendum (polls are close at the moment). If he does, he opens the door to Beppe Grillo and the Five Star Movement party, which wants a referendum on leaving the EU.

That’s one scenario. There are other ways it could happen. But anyway, the biggest worry in Europe is that Brexit results in a euro breakup. And obviously, that would be an absolute nightmare.

European stock markets are freaking out over this. The FTSE Italia is down 12% as I write, (compared to about a 6% fall for the FTSE 100).

Not better off

The pound is down 10% against the dollar. That’s good for exporters, but it’s not good for the economy overall. It’s a transfer from people who sell things abroad to people who buy things abroad. It doesn’t make the country as a whole better off.

There are times when a depreciating currency makes a country better off – like, as per the example above, if a central bank prints money to relieve a monetary shock. But this is not one of those times.

So what does this all mean for your investments? First, real shocks matter a lot. Watch what’s happening with UK banks. If they go to Frankfurt, no amount of money printing will make up for it. Also watch what’s happening on the continent. More EU referendums could spell serious trouble for the eurozone and the EU.

For the world outside Britain, this is a monetary shock – which means it’s serious but curable. If the big three central banks have their heads screwed on, they can prevent this from turning into a global recession.

But to be honest, their record on this stuff is patchy. Sometimes they act but sometimes they don’t. Often they act late. And in that case, as I said yesterday, gold miners are the smart play.

Miners are risky, so don’t pile in with both feet. But if central bankers hesitate, the returns could be huge. Keep an eye out for a new service designed specially to help you do that, ready to launch this Friday.

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