Britain: Europe's most unpredictable country

To everyone’s amazement the election produced an unambiguous winner. But what about the losers? Apart from opposition politicians, many British workers, consumers and businesses inclined to celebrate the Tory victory will find themselves worse off than they now expect. The prospect of a stable government may well boost economic activity in the next few months, as businesses implement investment decisions suspended due to political uncertainty, affluent taxpayers regain their consumer confidence and the London property market rebounds. But by the end of summer, any such post-election euphoria could seem like a temporary sugar-high.

While the British economy was hailed in the campaign as the strongest in Europe, it was already slowing in the second half of last year, after the adrenalin-rush delivered by George Osborne’s housing subsidies and fiscal relaxation in his 2013 Budget. By the second half of 2015, with the eurozone crisis receding and the United States economy recovering from its winter freeze, Britain will probably find itself relegated from the top to nearer the bottom of the global growth league. The good news is that interest rates will probably stay at rock-bottom level and the sterling will weaken, helping exports gradually to improve.

Economic performance under the new government will mainly depend on four policy issues that were hardly mentioned in the election campaign.

First, interest rates decisions, although formally controlled by the Bank of England, are strongly influenced by broader government economic policies. Second, the Conservative obsession with eliminating budget deficits, although it will probably be abandoned half-way through the new parliament, will initially act as a drag-anchor on economic growth, both for standard Keynesian reasons and because it will further widen income inequality, thereby structurally weakening consumer demand. Third, there will be a completely new kind of economic uncertainty created by the potential break-up of the United Kingdom, Britain’s possible exit from the European Union and how these two pressures interact. Finally, there will be the challenge for Britain of continuing to attract huge global capital inflows to fund the world’s biggest trade deficit in relation to Gross Domestic Product (GDP). Starting with the last two issues, the challenge is clear. While Britain previously stood apart from the eurozone crisis as a haven of political and economic stability, it will now be Europe’s most unpredictable country—not so much in its domestic politics, as I had expected prior to the election, but in its relations with the EU and the rest of the world.

Since a current account deficit worth 5.5 per cent of national income makes Britain far more dependent on inflows of foreign capital than any other major industrialised country, the EU referendum carries big economic risks, since a pro-EU vote now looks much less certain than before the election. The EU referendum will probably be closer than previously expected for several reasons. UK Independence Party supporters will be both infuriated and energised after winning double the votes of the Scottish National Party and emerging as Britain’s third largest party, but securing only one parliamentary seat. Tory Europhobes will be similarly galvanised by the extermination of the Liberals and empowered by David Cameron’s small majority. This dissident camp will be stridently supported by the right-wing press, its self-confidence revived by the Tory victory, and especially by the Sun, giving full vent to Rupert Murdoch’s implacable Europhobia and seizing the opportunity of Ukip’s unexpected success in northern England to open an aggrieved populist second front against Labour in strongholds that were previously invulnerable to Tory frontal attacks.

Most importantly, the EU referendum will interact with Scottish nationalism in several destabilising ways. The SNP may well form an unholy alliance with Ukip and Tory Europhobes to argue that EU referendum votes should be counted separately in England and Scotland. The almost inevitable divergence between public opinion in the two nations could offer the SNP an ideal pretext to call a second referendum on independence, perhaps even simultaneously with the UK referendum on the EU. The momentum of separation will be accelerated by the interaction of fiscal devolution and “English votes for English laws.” If Scotland wins the right to set its own taxes, “English laws” will have to include financial issues. At that point, the English parliamentary group will turn the UK parliament into an empty vessel, rather as the Russian parliament drained the Soviet Union of significance, once Boris Yeltsin gained fiscal powers.

Long before this possible separation, Scottish devolution will transform UK fiscal policy. Nicola Sturgeon, as a good Keynesian economist, will understand that Scotland would be mad to accept responsibility for setting its taxes and spending plans without the corresponding freedom to borrow in financial markets, which the UK Treasury is determined to deny. To accept such a pre-Keynesian poisoned chalice would be to condemn Scotland to Greek-style austerity and debt servitude. The SNP will therefore insist on Holyrood’s right to borrow, as well as to set taxes and spending. That demand, in turn, could inspire a struggle over budgetary policy throughout the UK. The end result of such fiscal turmoil is impossible to predict but it will surely add to the uncertainties unsettling business and financial confidence in both England and Scotland. Which brings us, finally, to interest rates—the one item of clear good news in an otherwise murky economic outlook. The Bank of England has shown through its behaviour that it will do its best to support the economy through political uncertainty. If the economy weakens after the post-election euphoria dies down, this weakness will ensure that interest rates stay at their near-zero levels for the rest of this year—and perhaps all the way up to the EU referendum—and then remain lower than they otherwise would be. Be grateful for small mercies.