The response from financial markets to the Brexit – Britain’s decision to leave the European Union – follows a series of swift and at times devastating market reactions to poor policy decisions.

The reaction to America’s first failed TARP vote in the heat of the financial crisis and the pummeling markets took when Greece threatened to opt out of the Eurozone last summer are just two other examples. They illustrate the market’s ability to reverse or sway ill-conceived policy-making – a role far larger than its historical one of disciplinarian.

Repercussions from the UK’s vote to leave the EU have been swift and dramatic. The pound sterling plummeted to a 30-year low as equity markets tanked and flight to safe assets outside of the country ensued. The government has dissolved in confusion following several high profile resignations, including that of Prime Minister David Cameron. This is adding to the unprecedented uncertainty about which direction the country will go in next.

 Fall of pound sterling
Falling value of the pound sterling in the days after the Brexit vote
Image: Financial Times

What does this mean for markets?

Some of the power that financial markets have gained could be exacerbated in this unusual post-crisis world. US Federal Reserve Governor Lael Brainard has warned that cross-border financial transmission mechanisms, namely currency exchange rates, are more sensitive to even small changes in interest rates when rates are already at such low levels. The threat to already fragile emerging markets is of particular concern. China, already on thin ice, is struggling to defend its currency in the wake of the vote.

Barry Eichengreen of the University of California-Berkeley has also highlighted the undue burden that reserve currencies bear. A lack of high-quality, safe haven and liquid assets means that reserve currencies attract more than their fair share of bond purchases and currency appreciation. Remove the pound sterling from the basket of reserve currencies and the movement becomes even more pronounced. The sharp appreciation in the yen following the Brexit vote and the drag that places on Japan’s economy is evidence of this.

The financial crisis left markets more sensitive to external shocks, after it became clear just how interconnected we have become. Market participants have every reason to sound the alarm when a move as dramatic as the Brexit vote, which shakes the foundations of the post-World War II model of economic integration and diplomatic coordination, occurs. Extremism, populism, isolationism, whatever we choose to call it, threatens to take away in just one generation much of what we worked to establish after the carnage of two world wars.

In reaction, those British voters experiencing a kind of “buyer’s remorse” are looking for ways to reverse, or at least soften, the negative economic consequences of the Brexit vote. Constitutional experts are weighing the government’s options. Everything from a series of political maneuvers to a new referendum is being explored. For the sake of democracy, I side with acclaimed novelist Kazuo Ishiguro who argues that the country needs to hold a second referendum that clearly lays out the costs of leaving as well as remaining in the EU. As it stands, the democratic process has been hijacked by the one-dimensional referendum, which came about almost accidentally; three years ago, Cameron consolidated support for his leadership by shifting disagreement over Europe onto a future referendum.

A bigger role for markets?

Why does it matter? The world is undergoing a series of political identity crises, which means upheaval in the world’s largest economies could become the norm. Financial markets will react, which means market participants could end up with a larger say in the outcomes. Will that result in better policy decisions? Or will it merely punish and incense those left behind by those decisions? Violence against immigrants surged in the wake of the Brexit vote, revealing an underbelly of racism; it is hard to imagine this could be healed by markets alone. The tools of democracy, which take more time and evoke uncertainty, are still better suited for the job.

I take some solace from the fact that financial market participants are holding our elected officials immediately accountable for policy choices; someone should. The recent rise in nationalism, encouraged by fear mongering, is particularly unproductive, especially as it will most hurt the people who respond to it. There is no guarantee, however, that financial markets will make better decisions than our elected officials have. Financial market participants can be even more short-sighted than politicians in their time frame for returns. They bring with them their own sense of hubris and confidence that they, not voters, should control policy decisions. That could seed a whole new set of challenges.

We can’t undo or reverse globalization, but we can alter our path. Globalization and technological change have left major swathes of the population behind. Dealing with their plight must be part of any future model and will require major investments in human capital and infrastructure, something too many countries have neglected. Financial markets are no more likely to succeed at incentivizing that investment than our elected officials. Their push to determine near-term winners and losers could actually widen the gap that divides us. Democracies are about compromise, representation and equity. They operate with a conscience; markets do not.

This article is part of our globalization series. You can read more here.