'Hard Brexit' Is the Easiest Political Option for the U.K. and the EU

 | Aug 30, 2017 | 8:30 AM EDT
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The beginning of the third round of Brexit talks between the U.K. and the European Union confirms something I have been saying since shortly after the referendum: a "hard Brexit" is not the least likely scenario, it is the most likely.

Many people seem to believe that since the botched election in June this year that saw the Conservatives' majority in parliament diminished, the "soft" Brexit group has gained ground in the Conservative party. Recent talk by various government ministers about a transitional deal with the EU has encouraged investors to believe that Britain will not simply crash out with no deal on March 30, 2019, when the two-year notice period expires.

Even usually skeptical analysts consider the possibility of a cliff-edge exit as the least likely scenario. I would say this is partly because the alternative is too scary to contemplate.

The markets' optimism rests on the assumption that both parties will negotiate in good faith, putting the interests of businesses and ordinary people first, rather than petty political interests. If we change that assumption to instead put political interests first, we have a scenario in which a "hard" Brexit becomes the most desirable option for the U.K. Conservatives and also for EU politicians. Of course, none of them would admit it; they will say they work hard for the people, as always.

The biggest hurdle is money: more specifically, the financial settlement, as the EU calls it, or the "divorce bill," as the U.K. media calls it. Various reports have said the European Commission (the EU's executive arm) puts the gross bill at €100 billion ($119.6 billion), something that Britain rejects. Foreign Secretary Boris Johnson once said, when asked about the money, that the EU can "go whistle."

He later conceded that Britain will have to fulfill its obligations, but this is where things get really tricky for his Conservative party. The EU has said it will not move forward to discuss the future trading relationship unless there is an agreement of the financial settlement, rights of EU citizens already in the U.K., and the Irish border.

Of all of these, the financial settlement is the hardest from a political point of view. In June this year, the EU published a position paper outlining the main principles it believes should be the basis of negotiating this settlement. It wants the methodology to calculate the bill to be agreed in the first phase of negotiations -- the ones taking place currently.

The U.K. has not yet published a position paper on the financial settlement, although it has published papers on various aspects of its relationship with the EU after Brexit. The U.K. government has not yet given any details about how it wants to go about the financial settlement, either.

It will be very difficult for the Conservatives to tackle this issue. Former Prime Minister Margaret Thatcher remains in history as the one who went to Brussels and said "I want my money back," and obtained a rebate on the U.K.'s contribution to the EU budget. No Conservative Prime Minister will want to go down in history as the one who gave Brussels more money than absolutely necessary.

Any type of financial settlement that the ruling Conservative party would agree upon will be heavily criticized by the opposition and the media. A sum of money is easier to understand than any abstract issues such as influence, access to markets or reciprocal rights. It is also easier to criticize, by showing what could be done instead with the money.

The Leave camp themselves know all about this type of manipulation of public opinion, having promised to give to the National Health System £350 million a week that would be saved if Britain quits the EU, only to afterwards renege on that promise. They could see the tables turned on them.

This is why it is so difficult for the Conservatives to reach an agreement even on how to calculate the settlement bill, let alone the amount. A report by Politico quoting unnamed EU officials briefed by the U.K. government says that a senior member of the team of Brexit minister David Davis initially said a paper on the financial settlement will be provided, only to go back on that promise in a subsequent meeting earlier in August.

For the Conservatives, it would be politically easier to just keep the talks going, but not provide sufficient detail for them to advance far enough to allow going past the first issues to the future relationship. They could then tell their electorate that they tried, but the EU was "stubborn and inflexible," as David Davis was reported to have said.

For the EU politicians, this could be the easy way out as well. Technocrats would like a deal, because they know that a cliff-edge Brexit would hurt the EU economy too, not just Britain. But politicians would probably prefer it if Britain were to suffer badly because of Brexit, as it would prevent other members from leaving. Plus, they could blame the British for any economic weakness in Europe for a while.

Investors should expect increased turbulence for the British pound over the short term, and for both U.K. and European stocks and bonds over the longer term, if this uncertainty continues.

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