Britain Faces Post-Referendum Commotion

Still too many unanswered questions in UK politics

Originally published in the July | August 2016 issue

With Theresa May’s move into 10 Downing Street, at least the immediate political vacuum at the very top of British politics has been filled. While investors will have welcomed this clarification of political leadership, the inconvenient truth is that policy uncertainty remains huge, both on Brexit and the domestic economy. A closer look at developments in British politics reveals political risk is unlikely to abate from its currently elevated levels anytime soon.

May’s initial comments made it very clear: this is her government, and no continuation of the past. The sacking of seven of the most senior ministers including Chancellor George Osborne and Justice Secretary Michael Gove followed suit. The new PM has single-handedly gotten rid of the ‘Notting Hill set’ of senior ministers close to Cameron and Osborne, fired almost all of the Number Ten political advisers appointed by Cameron, and all of the advisers in the Treasury under Osborne.

May’s immediate action was swift, and the tone she struck during her first remarks outside the front door of 10 Downing Street was radically different from the by now old Cameron-Osborne days: the focus is on delivering Brexit, restoring the strength of the economy, national security – and, quite remarkably, on delivering greater social justice and an economy that works for all.

There is only one problem so far: following the ultimately very short Tory leadership campaign, the actual shape of the policies to be pursued remains largely unknown.

It is not that there would have been any lack of ideas. May and her new team have indicated that austerity will be relaxed in the next two years and played with the idea of stimulus spending, including on infrastructure. They have also pointed to plans for employee and consumer representatives on company boards as well as restrictions on foreign takeovers and executive remuneration.

It is clear that May wants to be seen as on the side of the less well-off, positioning herself right in the centre of politics. The only question is: how does she want to achieve this?

The same question will undoubtedly also haunt her on the most important topic of her premiership: Brexit. The domestic side of it May has played not without strategic skill. EU exit-related portfolios have been given to prominent Leavers – David Davis (Brexit), Liam Fox (Trade) and Boris Johnson (Foreign Affairs).

The PM’s goal is clear: ensure that the reluctant Remainer May cannot be criticised for watering down the commitment to leave. Once it becomes clear even to the most unrealistic Brexiter that painful trade-offs will have to be made, May hopes that the Leavers are in a better position to sell these to Tory MPs and Leave supporters in the country.

Given the deep divisions within the ruling Conservative party, May’s is a sensible strategy. Still, she remains in charge of the overall policy and might therefore find it difficult to distance herself entirely from the problems that will inevitably emerge.

How grave these problems might turn out to be should have become clear from the disconnect between Davis’ ideas for the negotiations with the EU (retain market access while limiting immigration) on the one hand and the reality of what Europe will be able to offer on the other.

France especially is under pressure from its own Eurosceptic movement at home, the National Front of Marine Le Pen. The country is going to presidential elections in spring 2017. President Francois Hollande has every incentive to use the UK as a scapegoat and the Brexit talks to send a very clear message to his own Eurosceptic electorate at home: flirting with the idea of leaving the EU is a bad idea because a country that decides to leave will really be worse off.

On the other hand, Germany will dearly miss the UK’s liberal-minded, pro-business approach to EU politics, and Chancellor Angela Merkel does not find herself under comparable levels of domestic anti-EU sentiment as Hollande. But – in contrast to what prominent Brexiters seem to continue to believe – that does not mean that Berlin is likely to be particularly lenient in the upcoming talks.

Not least as a result of German insistence on intergovernmental deals, EU institutions are fairly weak these days. On big decisions, therefore, the crucial meetings happen more often in Berlin than in Brussels these days. But while that means greater German influence on the surface of things, it also forces Berlin more than ever to construct a joint European position. That means taking into account others’ more hawkish views, particularly France’s.

On top of that, Germany’s own, strong interest in preserving the single market means that Berlin cannot really have an interest in offering the UK a better deal outside the EU than what would have been on offer for a member state. Feeling to a certain degree forced to make a choice between the single market and its own, substantial trade relations with the UK (around 7% of German exports go to Britain), many in Berlin reiterate the country’s massive dependence on the wider single market. In rough numbers, up to 60% of German exports go to the EU, about 40% to the Eurozone, and close to 10% to Berlin’s traditionally biggest European trading partner France.

The result of this pattern has already been clearly signalled to the new government in Westminster. Full access to the single market will only be granted in return for the UK accepting the EU’s so-called four freedoms (capital, goods, services – and, crucially, movement of people). The EU will be willing for the UK to limit immigration, but only in return for limiting access to some areas of its single market. This is the economic price the UK will have to pay.

Listening to Westminster’s new Brexit Secretary of course reveals a very different take on reality. This disconnect is precisely where the biggest risk lies for May. She will have to break it to large parts of her party, and indeed the country, that painful compromises will have to be struck.

Also, May will need to force her own party to eventually replace its habitual occupation with Eurosceptic fantasies with a serious, at times very technical debate about the UK’s actual preferences in the real world. How much immigration andof what shape is acceptable to the UK? How much market access is Westminster willing to trade in? And more specifically, in which areas shall the economic price be paid, and which sectors of the economy are to retain more or less unrestricted access?

The domestic British debate doesn’t even seem to have vaguely begun considering the vital trade-off between migration and market access. Neither does there appear to be any conception of the difficult bargains ahead within the country, between regions, sectors, professions, and companies.

To be sure, the tasks ahead for May would pose grave problems for any political leader. But if the Brexit referendum has proven anything, it is that existing levels of societal polarisation and political fragmentation are already at elevated levels. Just consider the looming Scottish question, growing doubts about the representative quality of the majoritarian electoral system, and the shambolic disconnect between a socially-liberal, centre-left parliamentary party and the culturally-conservative, far-left grassroots in the Labour party.

It does not take a great deal of imagination to see that political uncertainty within domestic UK politics will continue to act as a major source of political risk for the coming years. As uncertainty turns into the only certainty, one consequence for investors is clear: in the age of fragmentation, politics matters for market outcomes – especially in developed economies, and probably more than ever before.