Post Referendum Circular Reference

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It has been a fortnight since the UK electorate voted to leave the EU and the British political and financial landscape has already changed dramatically. But what we don’t know or can only tentatively forecast still dwarfs what we know.

The referendum result simply reflected a popular preference for the UK to leave an international organisation, nothing less, nothing more. There is no precedent for UK and EU leaders to rely on and Article 50 is at best only a very skinny rule book.

For all intents and purposes UK and EU leaders are flying blind. It’s not even obvious who is at the controls, let alone who will lead negotiations on behalf of the EU and in particular the UK following seismic changes in political personnel.

The next steps are thus anything but straightforward and the UK government and EU are currently caught in a prisoner’s dilemma, with none of the key players seemingly willing to make the first move.

The referendum result is not legally-binding, only advisory, and therefore the Lower House of Parliament will likely have to vote on whether to trigger Article 50. But the British government has so far provided only a vague wishlist and simply doesn’t know what the EU may or may not agree to.

Parliament will not want to kick start an almost irreversible process whereby the UK has announced a divorce but doesn’t know the terms and conditions of this divorce, let alone what its new relationship will look like. Unsurprisingly, the British government is playing for time.

But EU leaders have suggested that discussions about the UK’s exit from the EU and future trade agreements were conditional on the UK government first triggering Article 50. And that takes us back to square one.

When this deadlock is broken will depend on many variables, including the length of the stalemate itself, who is in charge at the point of making a decision and the ability and willingness of negotiating parties with different vested interests to compromise.

I would argue that the longer this stalemate lasts, the greater the likely damage to the UK and EU economies and the greater the odds that Article 50 is not triggered in the first place or that a mutually satisfactory deal is eventually reached. Early British general elections cannot be discounted, nor can a second referendum in a more extreme scenario.

Assuming that the current circular reference paralysing EU and UK leaders is unbroken near-term, the associated uncertainty will likely continue to weigh on the UK economy, sterling and global risk appetite. Whether this morphs into a deeper and more widespread crisis may boil down to how patient global financial markets are willing to be.

Political, financial and economic upheaval…and now for the hard part.

It has only been a fortnight since the British electorate voted in favour of leaving the EU. Yet, in that time, the UK political landscape has changed irrevocably, sterling has hit decade lows against the dollar and multi-year lows against other major currencies, the Bank of England has stepped in to facilitate bank lending and signalled likely policy rate cut(s) and domestic and foreign economic actors are still grappling to quantify the likely impact on households, businesses, governments and markets.

But now comes the hard part. The fact is that what we know so far is dwarfed by what we don’t know or can only tentatively forecast (see Brexit: more questions than answers, 28 June 2016). The many layers of uncertainty are financial, economic, political, diplomatic, legal and constitutional. Experts in one or even two of these fields can thus offer only limited predictions. Outside of war-times, it is difficult to recall a situation where the outlook for the UK in coming months, even weeks, has been so unclear.

The fundamental problem, which I elaborate on below, is that the referendum result simply reflected a popular preference for the UK to leave an international organisation, nothing less, nothing more. Moreover, there is no precedent for the UK and EU leaders to rely on. Article 50 provides at best only a very skinny rule book for the process by which the UK would formally announce its exit from the EU and negotiate the terms and conditions of its exit, which I summarize in Figure 2. It provides little or no framework for the UK to negotiate a new agreement with the EU, let alone new agreements with non-EU partners to replace those negotiated under the EU umbrella.

For all intents and purposes UK and EU leaders are flying blind, or at the very least flying in very heavy fog with defective instrumentation.

Who is in charge?

Actually, it’s not even obvious who is at the controls, let alone who will lead the negotiations on behalf of the EU and in particular the UK. A best guess is that the UK’s negotiating team will be a mix of pro-Leave and pro-Remain politicians and experts – a reflection of the tight 52% vs 48% referendum result – which could in itself muddy the UK’s negotiating stance. From a very practical perspective, the UK has only a small number of trade negotiators according to recent reports and may have to hire experts from abroad.

In any case the negotiating team will only be the tip of a very large and fractured political iceberg (see Figure 1).

For starters, the already fragmented Lower House of Parliament (the House of Commons) – eleven parties are represented – is also split along EU lines. Around three-quarters of the 650 Members of Parliament (MPs) are pro-Remain, with the ruling Conservative Party providing by far the largest number of pro-Leave MPs (around 135). Scotland and Northern Ireland are pro-Remain and their leaders could well play a key role in how things play out.

figure 1 olivier desbarres

Moreover, the almost comical changes in senior British political personnel which have hit the ruling Conservative Party, the opposition Labour Party, UKIP and the Leave camp, have created a power vacuum at a time when robust leadership is required. Prime Minister Cameron has handed in his notice but the 125,000 Conservative Party members will only appoint his successor – who will clearly play a key role in negotiations with the EU – on 9 September or potentially a little earlier. Two candidates are left in the running: Home Secretary Theresa May who is pro-Remain and currently the favourite and pro-Leave Minister for Energy Andrea Leadsom.

The leader of the opposition Labour Party, Jeremy Corbyn, has lost his shadow-cabinet and a (non-binding) confidence vote and thus lost the authority to contribute meaningfully to important debates about the UK’s future. The co-leader of the Leave camp, Boris Johnson, has unceremoniously stepped down, as has the leader of UKIP and most-ardent anti-EU proponent, Nigel Farage.

The picture is just as muddy on the other side of the negotiating table. The EU’s decision-making machine is built around three executive and legislative institutions: the European Council (presided by Donald Tusk), European Commission (presided by Jean-Claude Juncker) and European Parliament (presided by Martin Schulz). No country has the authority to negotiate on behalf of all 28 EU member states.

Article 50 of the Lisbon Treaty suggests that the European Council, which is made up of the 28 EU heads of state, will spearhead negotiations. German Chancellor Angela Merkel is certainly intent it would seem on side-lining the European Commission and Jean-Claude Juncker and driving the negotiating process with support from France and Italy. But the European Council ultimately represents the interests of 28 EU members – members with very different economies, political set-ups and aspirations – and reaching a consensus could be a tortuous process.

UK-EU stalemate likely for foreseeable future

As a result, the next steps are anything but straightforward and the UK government and EU are currently caught in a prisoner’s dilemma, with none of the key players seemingly willing to make the first move.

Importantly, the referendum result is not legally-binding, only advisory, and therefore the House of Commons will likely have to vote on whether to trigger Article 50 (Step 1 in Figure 2)[1]. But the British government has so far stated only its desire to i. stay in the single market, ii. gain some control over EU immigration, iii. stop (or at least reduce) its payments to the EU budget and iv. preserve London’s status as the financial capital of Europe. This is merely a basic wishlist – the British government simply doesn’t know what the EU may or may not agree to and based on other countries’ experiences it could take years to re-negotiate complex trade agreements.

If MPs voted tomorrow on whether to Trigger Article 50, they would effectively be voting blind. If they voted to trigger Article 50 (see Figure 2), they would kick start an almost irreversible process whereby the UK has announced a divorce but doesn’t know the terms and conditions of this divorce, let alone what its new relationship will look like (to my understanding it would require a unanimous decision by all 28 EU member states to reverse the triggering of Article 50). This state of limbo could last for years and would undoubtedly be damaging to the UK economy.

This likely explains why the British government is in no rush for Parliament to vote on whether to trigger Article 50 and is playing for time. Prime Minister Cameron has stated that his successor would decide whether/when Parliament would vote on this key issue and both Conservative Party leader candidates have said that Parliament should not trigger Article 50 until next year. At the current juncture, the government will want to informally start discussing the terms and conditions of the UK’s exit from the EU (Step 2) and sketch out an outline of a new trade agreement and any concessions on issues such as immigration (Step 3) before it triggers Article 50 and the two-year clock starts ticking[2].

leave and renegotiate eu olivier desbarres

However, Tusk, Juncker and Schulz have asked for the UK government to clarify its position as soon as possible[3] and suggested that the EU would not start discussing the UK’s exit from the EU, let alone future trade agreements and other policies until the UK government officially triggers Article 50. And that takes us back to square one. The British Parliament will first want assurances about the UK’s future relationship with the EU before it sits down to vote on Article 50.

 

Longer the stalemate, greater the odds of UK not triggering Article 50, but also of snap elections and second referendum

The longer this stalemate lasts, the less likely it is that global risk appetite rebounds in a meaningful way, the greater the likely damage to the UK and to a lesser extent EU economies, and the greater the odds that someone flinches, in the knowledge that doing so may undermine their negotiating position near-term but help secure an acceptable outcome sooner. But even then the outcome would depend on a number of variables, include the length of the stalemate itself and who is in charge at the point of making a decision.

Let’s assume that this chicken and egg dilemma extends well into 2017, by which point UK economic growth has slowed materially. In this scenario, it is possible that British popular opinion could have shifted in favour of the UK staying in the EU and the new prime minister may then have a number of options. If Theresa May, who has a Remain bias, is prime minister, she could ask the House of Commons to vote on Article 50 in the hope that Article 50 is not triggered.

She may even feel emboldened to hold a second referendum on EU membership before or after the parliamentary vote on Article 50, in the hope that it gives her government and the Conservative Party a stronger popular mandate to keep the UK in the EU and a decent chance for success if snap elections were called (even if it means wasting months preparing for another referendum).

If Andrea Leadsom becomes prime minister, there is a greater risk in my view of the UK government digging in its heels in the hope of eventually securing a favourable agreement with the EU.

What if EU decides to take the initiative?

Let’s now assume for the sake of argument that in this never-played-before and complex game of political poker, the EU folds first and agrees to at least informally start Steps 2 and 3 without the UK first triggering Article 50. After all, no EU institution can force the UK to officially trigger Article 50. Moreover, the EU executive will not want the current paralysis to set in as this could allow anti-EU sentiment in other EU member states to gain traction and antagonise key EU partners such as the United States already pressuring for a speedy resolution. A number of EU leaders, including German Chancellor Merkel, have also adopted a somewhat more conciliatory position towards the UK.

Let’s look in turn at three possible scenarios.

Scenario 1: EU offers UK new deal which in aggregate is worse, or significantly worse, than current set-up.

I think this is somewhat unlikely as it would antagonise the UK – a major trading, financial and security partner for the EU – and could encourage a nationalist backlash in other EU member states.

In this scenario, the House of Commons could well vote against triggering Article 50 on the grounds that is in the interest of the British public for the UK to remain in the EU on the current terms and conditions. After all the UK already enjoys a number of concessions which most other EU members do not, including the ability to set a zero VAT rate on certain goods and a brake on immigration under certain circumstances – the latter having been negotiated by Prime Minister Cameron six months ago.

Whether in this scenario the UK government would opt to hold a second referendum on EU membership would likely depend on the prevailing level of popular support for and against the UK’s existing membership to the EU. It’s not obvious to me whether a poor deal from the EU would swing popular opinion in favour of the status-quo or whether perversely it would strengthen the electorate’s resolve to leave the EU at almost any cost.

Scenario 2: EU offers UK new deal which is markedly better in aggregate than existing agreement.

This is an unlikely scenario in my view. While the UK government has a duty (at least implicitly) to respect the wishes of the British electorate, the EU does not. The EU has already made clear that unfettered access to the single market would have to go hand in hand with the free movement of labour and contributions to the EU budget. The EU will be weary of allowing the UK to cherry-pick generous new concessions for fear of incentivising other EU countries to leave the EU and re-negotiate their trade agreements on different or even better terms (the fear of precedent and contagion).

In this unlikely scenario, the House of Commons would likely vote to trigger Article 50 and the UK and EU would then get down to the nitty-gritty of the details of such an agreement.

Speedy resolution would require negotiating finesse which may be in short supply

Scenario 3: EU structures agreement in principle which both facilitates UK’s exit from EU and strengthens EU itself – dual objectives which on the surface admittedly appear incompatible.

Specifically, this draft agreement would have to meet at least part of the British government’s demands in order to secure Parliamentary approval. This in itself is complicated by the fact that Scotland and Northern Ireland are in favour of remaining in the EU and their leaders will have their own wish-lists.

Moreover, a draft agreement would likely have to reflect the EU executive’s willingness to address, or at least acknowledge, the mounting pressure from member states’ electorates for a reformed set of EU laws and policies, including on immigration. This would go some way in curbing the momentum which pro-Leave and nationalist parties are currently enjoying in other EU member states and also perhaps give Germany greater room to achieve some of its key objectives, such as greater fiscal union and reduced powers for the European Commission.

At the same time, such an agreement – or at least the process by which an agreement is reached – would have to be sufficiently onerous to the UK to discourage other EU member states from even contemplating to go down the same route. This last condition may be the easiest of the three to meet as that there is mounting evidence that uncertainty – both in the months running up to the referendum and since the referendum result – is negatively impacting the UK economy.

It is clear that reaching such an agreement would require great diplomatic and negotiating finesse from both sides, with the probability of success at least partly conditional on the personnel doing the bidding.

In this scenario, Parliament would likely vote to trigger Article 50 and the UK and EU would then get down to the nitty-gritty of the details of such an agreement.

Near certain short-term pain, possible long-term gains if markets show patience

This multiplicity of variables in play and possible scenarios makes any forecast tentative at best. But we can probably venture that the current circular reference which is paralysing both EU and UK leaders is unlikely to be broken near-term.

The associated uncertainty will likely continue to weigh on the UK economy and currency, via subdued confidence and wages, delayed spending, investment and hiring, and strains on government finances. The Bank of England if anything will have likely welcomed (tacitly) the boost to exports and tourism from a much weaker and more competitive sterling. At a global level, there is already clear evidence of risk aversion with US, UK, European, Japanese and Australian bond yields tumbling to new record lows, the price of gold at a two-year high and equities down 3% since the referendum (with European banks and UK real estate stocks particularly hard hit).

Somewhat perversely, the longer this stalemate the greater the likelihood that the UK and EU are forced into a mutually satisfactory new deal or that the UK simply decides not to trigger Article 50, with the latter scenario possibly involving early general elections and in a more extreme case another referendum. The lifting of the uncertainty, even if slow, coupled with attractive valuations could attract capital inflows in the UK and unlock domestic investment and spending.

However, the longer this stalemate lasts the greater the risk of a pronounced slowdown in UK and European economic growth – with global GDP growth already at a paltry 2.8% – and of more acute global risk aversion. Put simply, it may boil down to how patient global financial markets are willing to be.


[1]  The UK Parliament website states that: “The national result, once declared, will be final but it is not legally binding. The European Referendum Act 2015 does not include provisions to implement the result of the referendum; legally, the Government is not bound to follow the outcome. However, it would be very unlikely for the Government to ignore the outcome of the referendum”.

[2] Andrew Tyrie, the Conservative chairman of the Commons Treasury Select Committee, made this point a few months ago: “There’s everything to be said for delaying triggering Article 50, until preliminary talks have made some progress […].”The overwhelming majority of the electorate will accept that, by negotiating for a while before the two-year period, we increase the scope for securing a smooth transition, and minimising the short term economic shock that some commentators warn of.”

[3] Members of the European Parliament (MEPs) on 28th June 2016 passed a motion calling for the UK to commence formal negotiations by activating Article 50 of the Lisbon Treaty as soon as possible.

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