Three into two doesn’t go

By their nature, if referenda are to be used only for matters of the greatest import, a clear answer must be forthcoming and therefore only binary outcomes can be permitted. In fact, though the Brexit referendum voting slip had just Remain or Leave printed on them, the Leave campaign was a coalition of two different perspectives. Michael Gove and Boris Johnson wanted to leave the loss of sovereignty implied by being a member of the EU with its automatic imposition of any Brussels regulations, but did not wish to lose the ability to trade freely with the EU, particularly in financial services where the UK dominates Europe. Many in wealthy parts of the UK voted Leave for this reason. For Nigel Farage on the other hand, the key issue was control of immigration – the EU’s freedom of movement for people in the single market was not acceptable and many in the poorer parts of the UK voted Leave for this reason.

The UK thus finds itself in a situation of intransitive preferences, known as Condorcet’s paradox. This occurs when a society prefers A over B and B over C and C over A. For a single individual this is obviously inconsistent, but in a society of many different points of view, this state of affairs is quite possible.

The referendum shows that the UK prefers Leaving the EU to Remaining in it. However, leaving the EU requires that we have to choose between continuing to be part of the Single Market with its economic benefits and having constraints of the freedom of movement of EU citizens. EU leaders have made it quite clear that this is the price to be paid to be part of the single market.

Thus it is entirely possible that there is majority preference to Remain rather than no longer be part of the single market but have control of immigration, ie Remainers plus many of the richer Leave voters, and a different majority preference to Remain rather than not have control of immigration and continue to have full participation in the single market, ie Remainers plus many of the poorer Leave voters.

Theory shows that for society as a whole such intransitive preferences have no good solution and this is where the UK finds itself today – wanting to Leave but with no plan and the world laughing at it.

Boris Johnson, now in campaigning mode to be the next Prime Minister, proclaims that the UK can have both, but David Cameron has already admitted that the UK must choose. The next Prime Minister will thus have to choose between the interests of business and the City and the poor. As a Conservative the obvious course may be to save the interests of business, but such a course of action will further alienate the poorer sections of the country and boost the support for UKIP and its anti-immigration stance.

There is already speculation that France would be prepared to offer the new prime minister zero tariffs on goods (where the Eurozone has a large surplus with the UK) and controls on immigration from the EU but no passporting rights for UK banks in to the EU. This would be exactly what the Farage wing of Leave would accept, but do great damage to the City and Conservative supporters.

As ever in politics there will likely be a compromise with some damage to the UK’s access to the single market in services in exchange for some flexibility on EU freedom of movement.

In or Out – the UK’s European hokey-cokey

For the last 50 years the UK has had a tortuously ambivalent political relationship with the rest of Europe – the referendum will not resolve this. This is for reasons of both geography and history. As an island with nothing but sea to the west but a huge landmass to the east, the UK is both naturally separated, and hence different, from the rest of Europe and at the same time ineluctably tied to and influenced by what happens there. The UK is both a part of Europe and not a part of Europe. This is reinforced by the sharing of a common language with the largest economy in the world, so providing the US with its key gateway to the European continent. Half of the UK’s trade is with Europe, emphasising the importance of the relationship, and of course the other half is not.

Post-war history has highlighted the indecision of the UK with regard to its relationship with Europe. In the early days of inter-government discussions between the nations to discuss political and economic co-operation and integration in the 1950s, the UK was largely absent and played no part, believing such plans were of little interest or relevance to them. By the early 1960s this indifference had turned to concern as it became clear that important economic decisions were being made in Europe that were affecting the UK’s interests. Macmillan changed course and decided the UK needed to join the European project, but was dismayed to find that the UK’s entry was vetoed by de Gaulle’s. So the 60s was a decade of the UK banging on the door of Europe but not being allowed in.

Ted Heath’s premiership in the early 70s was built around heavy diplomatic efforts aimed at negotiating the UK’s entry into the Common Market. This was finally achieved in 1973 at which point domestic politics intervened and Labour came to power with an election mandate to renegotiate the terms of entry which had only just been agreed, and then to hold a referendum. The renegotiation delivered very little and the public voted 2 to 1 to stay in.

For most of her premiership in the 80s, Margaret Thatcher was a convinced pro-European, because she saw it as good for business, and it was she who pushed hard in negotiations with the rest of Europe to deliver the European single market – the UK at this time was consistently arguing for more European integration, with opposition from much of the rest of Europe!

This reversed dramatically in the 90s as Jacques Delors led the European drive towards monetary union and the creation of the euro. In the UK this was seen as a backdoor way of seeking greater political union and sparked the rise of the Eurosceptic wing of the Conservative party, which has been the key faultline within the party ever since. Major European initiatives since then such as the Schengen free travel area and the single currency have seen the UK opt out, while letting others move forward together in greater integration.

The Blair and Brown governments in the Noughties were keen to be seen as leading Europe, with both men seeking to extend British influence by positive engagement, but increasingly the UK media railed against Brussels bureaucracy and increasing European regulation.

David Cameron was forced, for reasons of maintaining short-term party unity, to cede a second referendum, and polls, with less than a week until the vote, show a nation badly split over whether to remain in or leave the EU.

Though the shorter term consequences of the vote will be significant, on a longer term view, the UK’s essential ambivalence in its attitude to Europe will persist.

A victory for Remain will be seen as a rather grudging acceptance that the economic benefits of staying in (which have been very real for the UK economy over the last 40 years) are worth the perceived loss of sovereignty and democratic accountability, but there are few in the UK who have made an emotionally charged positive case for Europe. The UK would continue to be in but the tone will be reluctantly in – the historic ambivalence will continue.

A victory for Leave, though at first sight a clear statement that the UK does not wish to be tied to Europe, will not bring to an end the need for close understanding of European rules. The most successful UK , in services, in order to trade successfully with Europe, will be forced to comply with whatever regulations the rest of Europe decides to impose, not just with regard to those specific industries but also more generally with regard to European laws, which the UK will have no part in deciding.

The UK’s destiny with Europe is thus set to remain halfway “In” and halfway “Out” – the UK’s European hokey-cokey. The referendum will be a significant event in the UK-European relationship but will not change that fate.

The BoJo manoeuvre

It is May 2018 and the Prime Minister is in reflective mood, relaxing in 10 Downing Street with a drink. Fortes fortuna luvat was the phrase that sprang to his mind, or “fortune favours the brave” for those not lucky enough to enjoy his classical education. He was thinking of the book he would later write describing how he had emerged not only as the man who saved both the United Kingdom and the European Union, but, more importantly, how he had succeeded where his long-time rival, Dave, had so conspicuously failed. History, he was confident, would be kind to him.

Perhaps brave was not really the best word to describe the fairly straightforward political calculation that, whatever happened in the referendum, as the most prominent Conservative to stand on the Leave side of the debate, he was the obvious choice for Conservative activists to vote for as the leader to follow Dave. The fact that he didn’t himself really believe that Britain should leave the EU had been hidden away in a distant corner of his brain for the duration of the campaign.

There had definitely been a strong element of fortune though. The 50.3% victory for Leave was clearly affected by the torrential rainstorms that hit the UK in the late afternoon of June 23, 2016. The pensioners had been able to vote to Leave in bright sunshine in the morning, but a combination of storms and England playing in the European football championships in the early evening meant a much lower turnout amongst the younger generations, who polls showed were much more inclined to vote Remain.

Though Dave had initially wanted to stay on as Prime Minister, the backbench Conservative MPs quickly made it very clear that his time was up and he announced his resignation the weekend after the referendum. He felt it inappropriate to invoke Article 50 of the Treaty of Rome and start the clock on the two year timetable that would lead to Britain’s exit from the EU, saying that was a decision that should be taken by his successor.

Boris became Conservative Party leader, and Prime Minister, in September at the Party Conference, but the British public had already begun to experience doubts about the wisdom of its referendum decision in the intervening three months. Stock markets, not only in the UK but also in Europe had fallen sharply and a surprisingly large number of businesses announced their intentions to move their European headquarters to somewhere inside the EU – investment intentions and economic confidence had been hit very hard following the vote.

Not surprisingly the global banks such as J P Morgan, Goldman Sachs and Deutsche Bank clearly had well-developed contingency plans and were quick to announce their intention to move jobs from the City to Frankfurt and Paris from 2017 onwards. However what had taken many by surprise were similar announcements from key global manufacturing companies such as Siemens, Toyota and Pfizer and the withdrawal of EdF from the Hinckley power project, on advice from the French government, had left the UK’s long term energy policy in tatters. The number of announced lost jobs directly attributable to the referendum decision was much greater than even the Remain proponents would have dared to suggest in the campaign.

With Donald Trump, the Republican candidate in the November Presidential election, telling everyone how unhappy he was over the his treatment by the Scots over his dream golf course and saying that the UK had no chance of a trade deal if he was President, the UK economy was moving rapidly into recession amid massive uncertainty.

Given this backdrop, Boris also chose not to invoke Article 50, arguing initially that it made more sense to await the outcomes first of the US elections, and then the French and German elections in 2017 – after all there was no point in beginning negotiations with the EU when the two leading nations would not want to agree anything until their domestic political situations were clarified.

The European nations were also surprised by the drop in confidence in their stock markets as investment intentions declined further. The ECB were at the very edge of what was possible in terms of negative interest rates and QE, and fiscal policy remained constrained by German orthodoxy. What Europe had not expected though was the loss of respect from both the US and China, with many very rude comments about their irrelevance in the world without the UK coming from Trump and leading Chinese politicians. The continuing refugee crisis also tested to the limit the desire to maintain the Schengen area freedoms.

The critical factor had however come from Putin, who sensing Europe’s weakness has invaded and occupied Eastern Ukraine and was openly considering its annexation as he had done with Crimea. With the US consumed by its election it was left to Europe to take the lead in responding and they realised they needed to have the active and committed support of the UK.

Both the UK and Europe thus found themselves staring into an abyss in the months following the first referendum and were very frightened by what they saw.

Europe remembered that the initial vision for the EU had been to end war within Europe, and to that end the full-hearted involvement of the UK was now key. Compared with that even the free movement of labour, so beloved by the former Eastern European nations, could be seen as secondary.

So Boris had found it fairly straightforward, once the new German government had come to power, to seize the opportunity and come to a new reform agreement with the EU, which allowed the UK to control which EU residents could stay in the country, and allowed the UK much greater freedom not to implement bureaucratic EU directives. This dealt clearly and satisfactorily with the issues of immigration and sovereignty that had led many in the UK to vote to leave in the first referendum. The second referendum saw a Remain vote of 65%.

He had achieved a rare unity – the English were pleased with him, the Scots were pleased with him and even the Europeans were pleased with him. His place in history was now assured and, best of all, future historians would be able to compare directly the two referenda and prime ministerial performances, one dismal failure under Dave, one major triumph under himself.

2015 – a double election year?

2015 looks set to be a particularly political year, with the possibility of there being two general elections looking increasingly plausible. In the last six months, the strong performance of UKIP in the European elections and the SNP in the referendum vote, have seen UK politics move from the three party affair thrown up by the 2010 election (itself a radical departure from the two party politics naturally favoured by a first-past-the post system) to one where the fortunes of five different parties need to be considered to determine the final outcome of the 2015 election. One could add the Green party as a sixth, given their existing one seat and recent improvement in the polls.

In a constituency system with just one vote, a candidate merely needs more votes than any other candidate, and does not need the support anything close to half the electorate to win. In a 4-way competition, just 25.1% could theoretically be sufficient to win the seat. Thus the impact of new parties drawing votes from existing parties can make predicting the winner of any individual constituency incredibly difficult.

UKIP are currently showing at 17% in the opinion polls, with their support being drawn approximately ¾ from former Conservative voters and ¼ from former Labour voters. This could be enough to win a handful of seats, but the more important national impact could be the split in the Conservative vote allowing Labour to win some individual constituencies where they would not otherwise expect to have sufficient support.

The interest and passion displayed by the Scottish electorate in the independence referendum has continued since then and the SNP has in recent polls been drawing huge support from former Labour voters in Scotland, where Labour currently holds 41 seats, which are now under threat.

Support for the Liberal Democrats collapsed from the 26% achieved in 2010, from the moment they reversed stance on student fees in the initial Coalition Agreement. Their 7% showing currently in the opinion polls is very poor but their MPs tend to have built large local support bases in their constituencies and they are likely to win more seats than their national support would suggest.

The two major parties have not between them garnered the support of more than 2/3 of the electorate since the last election campaign (in 1945 they took 95% of the vote, but have been in decline since then). The current distribution of constituencies favours Labour, who hold many inner city constituencies where the size of the electorate has shrunk over the years, whereas Conservative constituencies are more concentrated in the suburbs where electorates have been rising.  Until recently, most analysts believed that Labour could win a parliamentary majority with just 35% of the national vote, whereas the Conservatives needed to win about 40%.  The recent rise of UKIP and the SNP probably means that these estimates need to be increased.

On current YouGov forecasts, not only will neither Conservatives nor Labour win a majority of seats, a coalition of either party with the Liberal Democrats will also not produce a parliamentary majority. The most likely outcome of the May 2015 election is thus a second election in October/November next year.

Opinion polls do fluctuate and there are still almost six months until the poll that matters, but the electoral arithmetic against a stable outcome looks difficult to overcome. For UK financial markets this may be troublesome in 2015.  This was always likely to be the case as a Conservative-led government would be committed to holding a referendum on EU membership in 2017, which would generate huge uncertainty in the minds of business with regard to investment in the UK, whilst a Labour-led government would be led by Ed Miliband, who would be seen as the most left-wing and anti-business Prime Minister that the UK has seen.

It is difficult to work out what a good election outcome would be for the financial markets.

Gilts or Kilts

In recent weeks the gap in opinion polls between those in favour and those against Scottish independence has narrowed from about 10% to about 5%. With some months of campaigning still to go, the vote on 18 September looks increasingly likely to be close. What are the likely political, economic and market implications of a Yes vote?

Political implications

  • Negotiating the split. The SNP envisage 18 months of negotiations prior to becoming independent on 24 March 2016. However, they would be negotiating with the UK government and there is a general election due in May 2015 which could easily lead to a change in the governing party or coalition. The outgoing government is unlikely to deem the negotiations as an important priority, and the new government may well have more pressing policy priorities than reaching an agreement with Scotland – the power is biased towards the UK Government in the timing and pace of any negotiation.
  • Impact on Westminster parliament. Should a new government be led by Labour, then they face the risk that after March 2016, with an independent Scotland in place, the Scottish Labour MPs would have no right to vote at Westminster. This could easily deprive such a government of their majority and could lead to a general election or a change in the governing party. Such a scenario gives a very strong incentive for a Labour-led government not to reach an agreement with the SNP. A UK parliament with no Scottish members would mean a near permanent majority for the Conservative party and a clear rightward shift in the political debate in the rest of the UK.
  • EU membership. Under current EU law, Scotland would have no automatic right to become a member of the EU – in theory, it would have to negotiate terms and win a unanimous vote from all the other countries. This is by no means certain as Spain in particular is likely to vote against such a move, given its concern about setting any precedents when its own Catalan people are calling loudly for independence.
  • United Nations. If Scotland were to leave the UK, it would be likely to reduce the global political influence of the rest of the UK. Its permanent seat on the UN Security Council might well be called into question, as it would be the smallest country with that privilege. Even today, with Scotland, the UK is less than 1% of the world population.

Economic implications

  • Currency. All three major UK parties at Westminster have been clear that they would not agree to a currency union with Scotland. In practice, however, they could not stop Scotland from using the pound, though in that situation Scotland would have no influence over the UK’s monetary policy set by the Bank of England. In theory (again), if Scotland were to become a member of the EU then any new member of the EU has to adopt the Euro as its currency. Creating a brand new Scottish currency is also possible, but would create the need for foreign exchange transactions and heavy costs for Scottish businesses.

 

 

 

A negotiated agreement, which created a formal currency union, would allow Scotland to keep the pound and possibly have a Scottish member on the MPC. However, events in the Eurozone in recent years highlight the dangers and effective loss of sovereignty in being a small country in a currency union when there is no fiscal or political union.

  • Banking system. RBS is the largest Scottish bank with a balance sheet of over £ 1 trillion at the end of 2013 (and this has halved over the last 5 years) with capital of almost £60 billion; given the size of the Scottish economy, a Scottish government could not credibly act as backstop should RBS get into financial difficulties again, whereas currently RBS does benefit from being an institution of systemic importance in the UK that the government is committed to supporting in extremis. Scotland’s ratio of banking assets to GDP is 12:1, which is higher than the peak levels seen in Iceland in 2007. It is likely that RBS would choose to relocate its headquarters to London, which would lead to the loss of a significant number of jobs in Edinburgh.
  • Dividing assets and liabilities. Scotland is about 8.5% of the UK’s economy and population. The SNP is claiming just about all of the UK’s North Sea Oil, its major resource asset, since it would lie in Scottish territorial waters, but only expects to take on 8.5% of the National Debt. The UK government might argue that North Sea Oil belongs to the UK today and so be prepared only to cede 8.5% of the resource asset. The stream of revenue from taxation on North Sea Oil is a key source of money to pay for future welfare spending in Scotland, and the SNP’s economic forecasts assume much greater tax revenues in future years than the forecasts of the current UK government.
  • Credit rating. As a relatively small and new country, with a reasonably high initial level of debt, Scotland would be likely to have a lower credit rating than the rest of the UK, even if there were a strong currency union in place; this will increase borrowing costs for Scotland. There is an additional danger that by reducing the size of the UK economy, and with investors implicitly believing that in a crisis the UK would come to Scotland’s rescue, that the UK’s credit rating would in fact be lower as well. Both countries could lose out.
  • Tax revenues. A number of Scottish-headquartered companies have indicated that it may be commercially necessary or desirable to have a UK headquarters for their business outside Scotland, due to all the uncertainties regarding currency, trade, tax, EU membership and regulation. This might substantially reduce the corporate tax revenue to a new Scottish government from Scottish companies.
  • Prices. Many companies in the UK have national pricing policies, which effectively subsidise providing goods and services to less central regions such as Scotland. Tesco have already indicated that they might adopt a national Scottish pricing policy, which would mean higher prices for Scottish shoppers.

Market implications

  • Currency markets. Sterling is likely to be viewed as a less attractive currency, since it may be backed by a smaller country and tax base than it is currently, and would generally carry less weight or influence in wider world affairs. The most likely market response to a Yes vote in the referendum would be for Sterling to fall against the other major currencies, and gilt yields to rise.

 

 

 

  • Effect on business investment. For business, a vote for independence would undoubtedly create a whole range of issues, about which there would be uncertainty and risk. On pensions, for example, there are completely separate EU regulations for pension funds which cover more than one country.  This may require large extra contributions by companies to deal with current deficits.   In financial services, many providers may judge that it would be preferable to be regulated by the FCA alone rather than by both the FCA and a new Scottish regulator, paying extra regulatory fees. Firms carrying out regulated activities might seek to move employees outside Scotland. All such uncertainties would be likely to lead to delays in investment spending by businesses.
  • Scottish bonds. A new market in Scottish government debt would need to be created, and such debt would be likely to trade at higher yields than the debt of the UK. UK government debts are called gilts and any Scottish government debt has already being colloquially labelled as “kilts”.

The possibility that Scotland might vote NO, but with a very small majority should also be considered.This could be the worst possible outcome since the SNP would undoubtedly believe that a second referendum, in say two years, might enable them to get over the line. International investment into Scotland would be likely to be damaged as investors would have no clarity on Scotland’s legal status and the UK government might well believe that it would derive little benefit from supporting the Scottish economy by, for example, relocating civil servants there.

In the long term, both Scotland and the rest of the UK could be viable, solvent, independent but closely allied, political entities – if both existed today, there would be no obvious reason or need to suggest they form one larger country. However, the transition from the current version of the UK to a smaller version would create major political and economic uncertainties that would be likely negatively to affect business and the economy in the short term. The period of negotiations spanning a UK general election is particularly unhelpful in this regard, and the ramifications on Scotland’s relationship to the EU are significant, but extremely unclear.

It is striking that with less than five months until the referendum, how many major unanswered questions there are about what would happen in the event of a YES vote. In no particular order, these are (i) what currency would Scotland use and how much influence would Scotland have over its monetary policy? (ii) would a newly independent Scotland be a member of the EU and on what terms? and (iii) what happens if no satisfactory agreement can be reached in any negotiations between Scotland, the UK government and the EU? Clear answers to these questions would provide a much more satisfactory basis for Scottish voters to make an informed choice.

For now, assuming a NO vote with a reasonable majority, there are no investment implications. A narrow NO vote or a YES vote would be likely to be negative (but not hugely so) for the bond markets and for the currency, but the weaker currency would be likely to be a positive for the stock market. The impact on financial markets would depend on how constructive the UK government and the European Commission choose to be in dealing with the Scottish representatives seeking to create a new country.