If the impact of increased uncertainty on investment is the only reason for the Bank of England to change interest rates post BREXIT, then it is important to recognise that a cut in interest rates could increase, not reduce, the relative value of waiting. Most investment decisions come with the option of waiting, and the relative value of this option increases not just when uncertainty rises, but also as interest rates fall. In other words, it becomes optimal to wait longer, as the value of waiting for more information goes up when either the future is less heavily discounted or uncertainty rises. Furthermore, the impact of the value of waiting is magnified at low interest rates. While any decision on monetary policy involves weighing up the (potentially competing) implications of a wide range of factors, this aspect of the option value of waiting has received little attention, and it will be important to add it to the mix.

The vote to leave the EU on June 23 has significantly increased regulatory uncertainty in the UK. No one knows how the UK’s domestic regulatory environment will evolve once it is “freed from the shackles” of EU regulation. Similarly, no one knows what deal the UK will negotiate with the EU, creating uncertainty about the access firms based in the UK will have to the EU market. Although it is clear is that all the possible trade deals with the EU will increase trade barriers in some form or another (for more on why see here), no one knows what form the new barriers to trade will take. Furthermore, only time will tell if trade deals with countries outside the EU will be able to deliver better access than the UK would have been able to secure from within the EU. Indeed, even the terms of the UK's WTO membership will need to be renegotiated, as it is currently based on the UK’s adoption of EU rules, creating further uncertainty.
For obvious reasons this increased uncertainty increases the option value of waiting. If firms delay before making investment or hiring decisions, they may have better information about what the changes will be and therefore whether the decision will be profitable. As more information will help them make better decisions, they will put off making them for as long as possible, particularly where they involve sunk costs.
As more firms are likely to decide to wait and see before investing, this implies the economy is likely to slow. Therefore, in the wake of this increased uncertainty there have been calls by some for the Bank of England to cut interest rates immediately, as well as to increase the level of Quantitative Easing (QE) that they are undertaking.
To understand what impact this will have it will be important to consider the value to firms of waiting – the impact of discounting on investment hurdle rates for a given level of uncertainty means that the option value of waiting goes up, not down, when interest rates fall. Furthermore, at lower levels of interest rates this impact is magnified. In other words, as interest rates fall it becomes optimal to wait longer, as when the future is less heavily discounted the value of waiting for more information goes up. This will affect the trade-offs associated with cutting rates.
The reasons underpinning this mechanism are set out in a paper by Avinash Dixit in the Journal of Economic Perspectives and the calculations underpinning Chart 1 are based on the simple example he uses to illustrate how the option value of waiting works and why it is important. The chart compares the returns needed to trigger investment under the option value of waiting to the case where this option is not considered. It shows that the implications of the value of waiting become more important as interest rates fall, as the ratio of the returns that would trigger investment under the two cases rises and that these increases are particularly large at low interest rates, or increased uncertainty.
The good news is that the option value of waiting applies not just to investing, but also to disinvesting. The band of inactivity created by the benefits of waiting for more information can cut both ways. Therefore, under increased uncertainty and low interest rates, firms may wait longer before either scrapping investment or reducing headcount.
The real world is obviously more complicated than the example set out in Dixit’s paper, and the predictions of his model can be difficult to test. However, there is evidence to suggest that the mechanisms he identified play a role in practice. For example, where investment decisions are irreversible, periods of increased uncertainty are linked to delays in investment decisions. Similarly, hurdle rates measured from surveys of firms have shown no signs of falling since the start of the century, despite significant falls in bond yields, and firms’ stated investment intentions are much less sensitive to cuts in interest rates than increases. (For a summary of this evidence see the discussion in Section 5.b of the Independent Economists Group’s report on Investment, Growth and Capital Markets Union, which can be found here.)
This means that the Bank of England will need to consider the option value of waiting in its assessment of the implications of BREXIT for monetary policy. The impact of increased uncertainty on investment is obviously not the only factor that the Bank of England will need to consider. For example, any reduction in demand or employment may make it harder for firms or individuals to make interest payments on the debt that they hold, so cutting interest rates would help them. However, cutting rates would make things worse for other groups, such as savers and companies with defined benefit pension schemes (as pension liabilities go up as interest rates fall). It will therefore be important to include the impact of the option value of waiting on investment decisions when evaluating these trade-offs, as for a given cut in interest rates the value of waiting increases more if the level of interest rates is lower to start with.

[Updated version of blog post published on 28/7/16]

In an FT article on 25 May 2016, the head of the World Trade Organisation (WTO), Roberto Azevêdo, pointed out that the UK would also need to renegotiate its membership of the WTO once it left the EU. This important detail has been mostly forgotten in the on-going debate about our future relations with the EU. However, it is vital that agreeing the proposed terms of our WTO membership is added to the government’s to-do list as quickly as possible.
WTO membership underpins our trade not just with the EU, but with all 161 WTO members - the vast bulk of our trading partners. The UK joined the WTO as part of the EU, meaning its existing WTO membership is based on its use of EU rules, which will no longer apply, creating the need to renegotiate the UK’s membership agreement. This is not a situation the WTO has had to tackle before, so the exact procedures are unclear.
However, what is clear is that the list of issues that will need to be addressed will be significant, as WTO agreements cover all aspects of policy that might create barriers to trade - not just tariffs. Having torn up the old rule book, the UK will need to propose a new one. And the UK cannot simply impose new rules, as changes have to be agreed with other WTO members. This process will be complicated by the fact that changes to WTO membership terms that are detrimental to existing partners can lead to demands for compensation.
The WTO’s role in trade deals
The terms of the UK’s WTO membership will also be of interest to any country wanting to agree a bilateral trade deal with the UK, as they will form the starting point for negotiations.
WTO members agree to offer all other members the same terms for market access, which are known as the most favoured nation (MFN) rules. While it is up to the country what these terms are, countries are not allowed to discriminate between different WTO members. Therefore, WTO membership terms form the baseline for assessing new deals, making it hard for other countries to do this in the absence of agreed terms.
Furthermore, the WTO’s non-discrimination rules mean bilateral or regional trade agreements are only allowed under certain circumstances and are subject to WTO scrutiny to ensure they abide by the rules. This is something that could hold up any new UK trade deals, if there is no agreed baseline for the deals to be judged against.
The scope of the (re-)application process
Roberto Azevêdo characterized the UK’s situation post leaving the EU as being akin to the normal WTO application process in terms of scope and complexity and this process is neither easy nor quick. It covers not just tariffs, but also all the relevant laws and regulations that might affect trade in thousands of different goods and services. A full description of what is covered by the WTO application process can be found here, but the long list of issues includes:

• the structure of the agencies responsible for overseeing trade;
  
• tariffs and import quotas;
• the legal framework for non-tariff regulation;
• intellectual property rules;
• technical standards;
• licencing rules;
• transit rules;
• rule of origin rules;
• subsidies and tax incentives;
• agricultural policy;
• public procurement rules;
• foreign direct investment rules; and
  
• the rules that affect trade in services.
  

Tailoring a UK solution
UK trade has been covered by the EU’s rules for almost all these things. The easiest option might therefore be to adopt all the relevant EU rules and, where necessary, to create new agencies to replicate the work of EU bodies. This might make the WTO renegotiations easier, as our trading partners would experience more limited change. It could also make it simpler to negotiate a new trading arrangement with the EU, as some of the options being considered depend on following EU regulations.
But if we are leaving the EU in order to take back control of our regulatory environment, is this the right choice? Or should we look at each rule with fresh eyes, to see if the UK would benefit from a different solution? And in any cost-benefit analysis, how should we weigh the competing attractions of the greater speed and regulatory continuity that the wholesale adoption of EU rules would bring, versus the potential, but uncertain, benefits that might be available if we took the time to explore a UK tailored solution?
It is not a given that the other 161 WTO members will allow us to renegotiate significant changes to our membership rules, but if that is what we want, now is the time to try. Apart from anything else, as these rules will underpin our trading regime, potential partners will want to know what they will be before agreeing any bilateral trade deals.
It is time to articulate a vision for what we want our trade and regulatory environment to look like. The need to negotiate WTO membership raises a long and complex list of questions, and we have the option of redefining the rules. Existing EU solutions may well be the right ones, but we owe it to ourselves to at least assess the options fully, in order to give BREXIT the best chance of success.