NOTE

Brexit’s Political Risks Overwhelm Economic Analysis

by Jacob Funk Kirkegaard | July 8, 2016

When Wall Street strategists start wading into political analysis, it’s often a sign that fear has gripped financial markets.

So it is with the United Kingdom’s referendum decision to exit the European Union. The biggest source of uncertainty for the rest of Europe from Brexit comes not from its immediate economic impact but rather the domestic political drama unfolding in the United Kingdom itself. Brexit has already unleashed chaos inside Britain’s two main political parties, and the situation continues to change dramatically almost by the day.

The two chief Conservative rivals in the EU referendum campaign—Prime Minister David Cameron and former London mayor Boris Johnson—are now gone from British politics, while the Labour Party continues its descent into potential electoral oblivion. The Conservative party leadership race has come down to a contest between Home Secretary Theresa May and Energy Minister Andrea Leadsom, significantly to the right of Cameron on most policy issues. The possible exception, ironically, is fiscal policy, since Brexit has caused Chancellor George Osborne to finally abandon his tight spending policies and pledges to deliver a government budget surplus in the UK by 2020.

This could easily turn into a very nasty contest, particularly because Conservative party members will get to choose between a candidate who supported Remain and one who supported Brexit. A big political question is whether the Conservative Party, and hence the UK government, must be led by a pro-Brexit candidate, or if a Remain supporter can be trusted to implement the will of the British people.

The likely defining question in the leadership campaign will hence serve to cement the bitter divide in the Conservative Party over EU membership, rather than provide a platform to reunite the party after the referendum.

In light of how Theresa May received the support of the overwhelming majority of Conservative members of parliament (199 votes) against just 84 for Andrea Leadsom, if the Conservative party members in the end chose Brexiteer Leadsom, it would also be a rebuke of Conservative MPs and crystalize a split between Tory party members and their MPs, akin to what has been unfolding in the Labour party. Should the final vote among Conservative party members also be quite close, the new Conservative leader would take the helm of the UK at a critical juncture of the country’s history with a very weak political mandate from his/her own party. This could make calls for an early—and very open—UK general election impossible to ignore. Particularly for Andrea Leadsom, not supported by the majority of her fellow MPs, an early election would appear to be politically appealing.

Theresa May has signaled she does not intend to launch Article 50 until into 2017, while Andrea Leadsom appears to favor an earlier start to negotiations. Should May win, this would cause a potential clash with the European Union later in the year, the other members will want Article 50 negotiations to start soon after a new prime minister is elected. The members of the EU 27 do not, however, have any legal means to pressure the UK to launch the negotiations. All they can do is stonewall London until it does and then wait until persistent economic uncertainty begins to take its economic toll on Britain.

Both Conservative candidates appear hawkish on immigration, suggesting a willingness to sacrifice access to the Single Market to retake full national control over this politically critical policy subject. As such, the Conservative leadership contest now looks to have made any compromise with the EU on immigration and Single Market access more difficult and even raised the prospect that a deal may not be reached once Article 50 is invoked.

At the same time, at least Andrea Leadsom and now a majority of the UK Parliament have opposed the UK government’s unwillingness to immediately guarantee the status of EU citizens now residing in the UK. The fact that the UK government, including Theresa May as Home Secretary, seems intent on using the status of EU citizens who legally moved to the UK as bargaining chips in the Article 50 negotiations—rather than immediately seek mutual guarantees for all current EU citizens living in the UK and UK citizens living in the rest of the EU—is potentially damaging to the political negotiating climate between the EU and UK. Any attempt by the UK to unilaterally change the legal status of EU citizens lawfully living in the UK would be met with a furious and uncompromising EU response, virtually guaranteeing a collapse of the negotiations. That several Conservative MPs, including Boris Johnson, joined the opposition Labour Party in demanding guarantees be granted to EU citizens in the UK suggests a new willingness of individual Westminster MPs to break party discipline on Brexit-related questions. This could be an important omen for future and more controversial parliamentary votes.

At the same time, the two leadership contenders have shown no desire for an early election in Britain, which is not surprising, given that there are four years left on the current Conservative majority parliamentary term and that MPs ever fearful of their jobs decide which candidates make it to the run-off. The situation could change, however, if the leadership contest is close and divisive and the Labour Party descends deeper into internal chaos. A situation of total disarray in Labour in the coming months may, despite the obvious political risks, make it politically irresistible for a new Conservative leader to seek a new personal public mandate to lead Britain out of the EU, following a bruising party leadership battle. The outcomes of any early election in the UK would be highly uncertain and will be discussed further below.

Meanwhile in the Labour Party, the existential struggle between incumbent far-left leader Jeremy Corbyn and his grassroots supporters and the vast majority of the rest of Labour MPs (80 percent of whom backed a vote of no confidence in Corbyn) continues. At stake appears to be nothing less than the Labour Party’s ability to be a governing party in the UK, as opposed to being an activist party pushing policy issues in the public debate. Like other center-left parties in Europe, Labour is struggling to address immigration, which the Brexit referendum showed is important to their traditional blue-collar working class core supporters around England. Corbyn stated during the referendum campaign that he did not favor restricting immigration to the UK, a position which—combined with his perceived lukewarm support for the EU during the referendum—has seemingly undermined support for him among his party’s MPs. Should it prove impossible to find a compromise in Labour, and the party witnesses a decline in support similar to that of many other center-left parties in Europe struggling with their immigration stance and partial abandonment of previous decades’ welfare policies—say to the 20 to 25 percent level of the German SPD, Dutch PDvA, or Danish Social Democrats—the UK’s electoral system would likely ensure that Labour’s representation in the UK parliament would drop dramatically. In contrast, continental Europe’s proportional election systems ensure even gradually shrinking center-left parties substantial parliamentary representation and political influence. As Labour risks no longer being a credible governing alternative to the Conservative Party, the traditional British two-party system could come to an end and be replaced by a more uncertain political landscape with only one large party (the Tories) and a number of smaller ones, including Labour, Liberal Democrats, the Scottish National Party, Greens, and likely an anti-immigration UK Independence Party. Such a historic political realignment of UK politics would greatly add to domestic political uncertainty during Brexit negotiations with the rest of the EU.

In light of the large public majority in Scotland that voted against Brexit, the Scottish National Party has now signaled their intent to proceed toward a second independence referendum. It is unclear how this will take place without the explicit consent of the UK government, as unlike David Cameron in 2014, none of the Conservative leadership contenders have shown support for such a vote. Scotland could likely rely on the support of some EU members as well as the European Parliament, while other members, especially Spain with separatist Catalonia in mind, would be adamant that no precedent be set for a country (UK) to leave the EU and a piece of it (Scotland) remain or be grandfathered back into the EU. Hence a transitional twilight period for Scotland being legally out but de facto still politically in the EU would have to be negotiated. The Scottish issue is moreover one area where the EU, should it be so inclined as part of the Article 50 negotiations, could play nasty with the British government. Generous publicly announced terms for Scotland’s “grandfathering into the EU”—all in the name of democracy and the will of the Scottish people—would fan the secessionist flames in Scotland, pressuring the UK government.

In the longer run, if the economic situation in the UK worsens as a result of the Brexit vote, a united Ireland might also become a real political option. Robbed of EU financial support, with London less able to commit scarce fiscal funds to Northern Ireland, facing a land border once again with the rest of Ireland, and with Irish Catholicism maturing into a less politically active and atavistic faith, a centrist majority for reunification on economic grounds might materialize. Catholic and unionist voters who care about the Northern Irish economy may in time chose the perceived economic stability of a united Ireland over remaining in the UK.

Copyright 2016 the Peterson Institute.