This article was originally published on Larry Summers' Blog.
Brexit is in train. If journalism is the rough draft of history, instant blog responses are even cruder responses to events. Nonetheless, here are some thoughts.
So far given the shock value of what has happened the market response has been on the calm side. The British pound is only a bit weaker than it was 10 days ago when the outcome looked highly uncertain. I would not have been surprised to see the pound below 1.30, the yen below 100 and more dramatic moves in credit spreads in the European periphery. Notably the pound which is a kind of bellwether and many other asset prices have rallied considerably from their lows during the night.
Relatively resilient markets so far probably reflect a combination of confidence that central banks will do whatever is necessary to maintain order as well as some opportunistic buying in response to opportunities created by the falling asset prices. Notably cool heads seem to be in control for now in London and Brussels. Fortunately authorities do not seem overly fussed with moral hazard at a time when the preoccupation needs to be maintaining liquidity and orderly markets. Critically, the market has expressed confidence that the Fed understands the gravity of the situation by taking the probability of a Fed hike by the end of the year down to the 10 percent range.
All of this could easily change when investors ponder the new and more volatile environment they live in, when traders decide they do not want to bear risk over the weekend, or when a weekend of pondering leads to a wave of liquidations on Monday morning. In 1987 volatile markets with international uncertainties at the end of the preceding week presaged the Monday crash. It is far too early for any kind of complacency.
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.