Britain & the EU: Not (yet) knockin' on the exit door

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Economic Research Note

Britain & the EU: Not (yet) knockin' on the exit door

 The UK is wrestling with two significant constitutional issues: the Scottish independence campaign, and the EU exit debate

 Britain may hold an “in/out” referendum on EU membership in 2017, but this is far from certain

 If a referendum were to be held, our base case is that British voters would opt to remain in the EU

 A British exit would impose costs for the region, but its ability to influence it is limited

The British government has committed to holding a

referendum on the UK’s EU membership in 2017. Despite the political heat that this issue has generated, we think that there are meaningful doubts whether the referendum will actually take place.

It is also unclear whether—if presented with the option of exit from the EU—British voters would choose to leave. Polling data suggest that the population is evenly split on the issue (first chart to the right). We believe that Britain would opt to remain within the European Union, for reasons we explain below. However, other factors could change this analysis—

including the potential for deterioration in the relationship between the UK and its main regional partners, or a crisis over Scotland.

Exit debate reflects long-term trends

The debate over a British exit from the EU is a function of two long-term trends. The first is the decline of existing certainties in domestic politics. The UK has experienced a shift toward greater Euroskepticism, and to a significantly more “anti-establishment” posture in voter behavior. This change has put the traditional two-party system in the UK under sustained pressure, as elsewhere in the region.

Both of the main political parties have been divided on the issue of Europe since the 1970s. The Conservative Party, in particular, has been shifting in a more Euroskeptic direction since the passage of the Maastricht Treaty in 1992. The rise of the UK Independence Party (UKIP) on an explicit “pro-exit”

platform has also shifted the center of gravity of British politics in a more Euro-critical direction. The recent European election results confirmed this trend with UKIP securing 27.5% of the vote—reflecting a shift to populist and “anti- system” parties across much of Europe.

In practice, we think the rise of UKIP reflects concerns about domestic politics rather than just the EU. Support for UKIP has decoupled from voter concern about the EU itself (second chart).

This is a consequence of the fact that the “anti-establishment”

political revolt in the UK has come to be reflected through a European prism. Voters in the UK view the EU as an elite project over which they have no control, but the main message in voter behavior is discontent with national government (this is also expressed in increased support for the Scottish Nationalists and the Greens). The main parties appear to us to be

misinterpreting the message. If the situation is handled poorly, they could lead Britain toward exit, despite the EU being a minority concern for most voters (chart on third page).

The mainstream parties are adapting to these political realities in the context of internal division. The Conservatives need to manage a significant internal constituency of members and Big decisions ahead for the UK

Sept 18th 2014 Scottish referendum on leaving the UK

May 2015 General Election (possible change of government)

March 2016 Possible Scottish independence, and new General Elections in Scotland and r-UK

May 2017 Possible date of EU exit referendum Source: British Government, J.P. Morgan

0%

10%

20%

30%

40%

50%

60%

Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14

%

Should I stay or should I go now?: UK polls on EU exit

Source: Polling companies,. JP Morgan

Stay Leave

Unsure

0%

5%

10%

15%

2010 2011 2012 2013 2014

%age of voters who support UKIP, and %age identifying EU as their key concern Votes for anti-EU parties are about much more than Europe

Source: IPSOS, JPMorgan

Certain to vote UKIP (General Election)

See EU as the main political issue for UK

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MPs who support an EU exit. This has incentivized the party leadership to take a tougher line on Europe, and related issues (such as immigration). Labour has faced less obvious division and has come down against a referendum, but the party also includes a significant number of MPs who would favor a vote on EU membership. The Liberal Democrats are the only major party with an explicit pro-EU leaning.

This domestic debate is exacerbated by the second key trend in the UK’s relations with Europe: the regional dynamics that have led to greater integration within the rest of the EU (particularly since the adoption of the Euro). In the eyes of British Euroskeptics, this has turned the EU into a very different institution from the body Britain joined in 1973.

There are legitimate long-term questions about Britain’s role in a union where its influence is in decline (particularly given that the UK has always had less ideological commitment to the EU than its European partners). The current debate over the composition and policy direction of the next European Commission has highlighted the difficulties that the UK faces, including with regard to the EU’s pursuit of “ever closer union.”

In response to these pressures, the prime minister has committed to holding an “in/out” referendum on the UK’s continued membership of the EU. This is intended to follow renegotiation of the terms of British membership, based on a Government audit of the costs and benefits of the UK’s relationship with the EU—the so-called balance of

competences review. The review is scheduled to be completed before 2015; it will then form the basis for a renegotiation with Britain’s regional partners, with a referendum to approve a revised membership package afterward. To date, the review has not produced compelling empirical evidence of the desirability or otherwise of an exit. In practice, given the political dynamics in play, nothing short of a referendum is likely to end the debate, in our view.

Two forks in the road to a referendum

The main outstanding question in the UK’s relations with Europe is whether a referendum will actually be held as anticipated. The prime minister made his commitment to an EU-exit referendum in January last year (for background see our note Britain and Europe: You can’t always get what you want…). However, the commitment postponed an actual vote until 2017, i.e., until after the next General Election (which is likely to be held in May 2015). The prime minister’s

commitment is not legally binding.

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It is likely that a new

1Constitutionally, it is extremely difficult for the British Parliament to bind any Parliament elected after it. Attempts, which we expect, by Conservative MPs to make the commitment legally binding by forcing through a Referendum Act in this parliament are unlikely to be successful, in our view.

parliament will need to legislate for the EU referendum, and it may choose not to do so, influenced by a number of key political “break-points” over the next year:

The first of these is the Scottish referendum on independence to be held on September 18 this year. If Scotland votes to leave the UK, we expect this to remove most of the doubts as to whether a referendum on EU exit will be held. It may also make the vote much harder for pro-Europeans to win. The sequence of events may run as follows:

i) Transformation of the party system: The “loss” of Scotland would likely make the prime minister’s position untenable in the medium term. The Conservative Party may elect a new leader, who, given the current composition of the party, is likely to be more Euroskeptic. Labour would face structural crisis, given that it would lose its Scottish support base (currently worth 40 MPs, to 1 for the Conservatives).

ii) Second General Election required in 2016: Regardless of who wins the General Election scheduled for 2015, there would likely be a constitutional requirement for a new election in 2016, when Scotland becomes independent, as the UK would cease to exist in its current form. In the interim, any government elected in 2015 would only remain in office for 9-12 months (if it is a Labour government, elected with Scottish seats, it would face significant legitimacy issues).

iii) Conservatives campaign under Euroskeptic leadership: We think the new election in the rump-UK in 2016 likely will be won by the Conservatives, given the loss of Labour’s Scottish seats. Under more Euroskeptic

leadership, the party would have a mandate to hold an in/out referendum in 2017—and could conceivably campaign to leave, rather than to stay in, the EU.

iv) Rump-UK votes, in nationalist mood: Voters in England, Wales, and Northern Ireland would vote in the EU referendum against a backdrop of anxiety brought about by the end of the UK—and the reduced role of its successor state.

A nationalist shift toward EU exit seems plausible.

Assuming that Scotland remains within the UK (which is our base case)

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, the second key fork on the road to a referendum on EU exit would be the UK General Election scheduled to be held next year. At this distance, we view the election as too close to call—but an outright Conservative victory looks doubtful.

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If the Conservatives win a parliamentary majority

2We have written on Scotland extensively. For more detail see our notes "Assessing the prospects for Scottish independence," “The Economics of an Independent Scotland,” and "What if Scotland votes yes."

3This is a function of the headwinds faced by the Conservatives; i) the electoral system, ii) political division on the right, and iii) historical precedents on attitudes to incumbency. The electoral system significantly disadvantages the party. In 2010, David Cameron secured a larger

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we expect the referendum to go ahead as planned. Under a Labour government, the chances of a referendum would recede. Labour has indicated that it will only hold a vote if the UK transfers more powers to the EU. This view may change under internal or electoral pressure (particularly if Labour faces additional difficulties before May). However, our base case is that a Labour government would not hold a

referendum.

If neither party secures a parliamentary majority, as seems likely at this stage, the situation will become more complex.

There would be negotiations over a new coalition (likely involving the Liberal Democrats). In this context, the Conservative referendum commitment could create complications. If the Conservatives are the largest party, it may nonetheless struggle to find coalition partners given its views on Europe, and could lose office as a result. One possibility is that the Conservative party tries to form a minority government

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that could theoretically call an in/out referendum, if sufficient support from Euroskeptics in other parties could be found. Complications in the political process are conceivable in all of these scenarios.

Voter bias will probably be to stay

The second big question for the UK is how voters would behave if a referendum were to be held. Our inclination is to believe that British voters would opt to remain within the EU.

“Status-quo bias” (defined below) and risk aversion mean that the barrier to exit is high, and voters are significantly less exercised about EU issues than headline figures suggest.

However, there are significant uncertainties around this.

The key structural issue in this assessment is what we define as a status-quo bias. Voter behavior on major constitutional matters, in the UK and elsewhere, tends to be sticky toward the status-quo; voters are usually unprepared to make constitutional leaps into the unknown—unless the case for change is very clear. A survey of recent constitutional referenda in comparable jurisdictions (table to the right) highlights the trend. In the table we group constitutional referenda into three segments; i) measures to introduce devolution; ii) measures to alter the mechanics of

government, and iii) measures that involve major systemic change (and a significant break from the past). The data suggest that people will mostly take the perceived free lunch of extra representation, but they display risk-averse behavior

share of the vote than Tony Blair achieved in 2005. While Cameron has been forced to govern in coalition, Blair had a working majority. In addition, support for UKIP, even if only partially resilient, disproportionately harms the Conservatives. We will write more on this in due course.

4This is an arrangement under which the governing party lacks a parliamentary majority, but secures ad-hoc support on individual pieces of legislation.

Voters have a status-quo bias in constitutional referenda…

Yes No

Transformative changes

i) Australia 1999 Establishment of a Republic 45.13% 54.87%

ii) Quebec 1980 Independence 40.44% 59.56%

iii) Quebec 1995 Independence 49.42% 50.58%

iv) Northern Ireland 1973 Union with Ireland 1.10% 98.90%

Devolution

i) UK 1998 Establishing London Assembly 72.00% 28.00%

ii) Northern Ireland 1998 Good Friday Agreement 71.10% 28.90%

iii) Scotland 1997 Scottish Devolution 74.30% 25.70%

iv) UK 2004 Devolution for Northern

England 22.10% 77.90%

v) Wales 1997 Welsh Devolution 50.30% 49.70%

vi) Wales 2011 Welsh Devolution 63.49% 36.51%

Structural changes

i) UK 2011 Alternative Vote 32.10% 67.90%

ii) New Zealand 2011 Change to electoral system 42.20% 57.80%

iii) New Zealand 1999 Reduce number of MPs 81.46% 18.53%

iv) New Zealand 1992 Change to electoral system 84.70% 15.30%

v) Ireland 2013 Abolition of the Senate 48.30% 51.70%

NB: This is not intended to be an exhaustive list of referenda, it covers matters related to narrow constitutional questions, rather than social issues, etc.

Source: National governments, J.P. Morgan

0 10 20 30 40 50

UKIP voters Conservative

voters Labour voters Lib-Dem voters

%

...and aren't focused on EU issues:

Source: Ipsos

EU Economy

Immigration

Unemployment

0 10 20 30 40 50

84 89 94 99 04 09 14

% of British voters identifying the EU as the top political issue facing the UK A 30 Year View: The EU stopped being a core issue 10 years ago

Source: IPSOS, JPMorgan

Debate over Maastricht, possibility of UK joining EMU

Becomes clear that UK isnt likely to join EMU

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toward constitutional change that would remove existing relationships or provisions.

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We think it is reasonable to expect that voters could overcome this risk aversion if they feel sufficiently strongly, and if a clear case for change has been made. However, most British voters are significantly less concerned about EU issues than the headline performance of Euroskeptic groups suggests. For the past five years, polls have consistently failed to place Europe or the EU in the list of the top 10 concerns for British voters. Even among self-described UKIP voters, only 8% of respondents describe Europe as the most important issue facing the UK

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(first chart on third page). For the most part, support for UKIP reflects changes in political culture, distaste for the political establishment, and concern about other issues (notably immigration and race relations).

British voters do not appear to like the EU (chart to the right) but neither are they especially interested in it. This reflects long-term historical trends (highlighted in the chart on page 3). The focus on Europe peaked in the late 1990’s following the divisions over the Maastricht Treaty. Since the prospect of further integration of the UK receded around a decade ago, voters have tended to focus on other issues. This creates a paradox in voter attitudes, given the headline level of support for leaving the EU reflected in national polls (chart on page one). We think Euroskeptics are only likely to be successful in the long term if they can continue to link other issues—

immigration and the economy—to the EU institutions. It appears unlikely that the electorate will see enough evidence to cause it to break its structural bias to the status-quo—

assuming that the context in which a referendum takes place is supportive.

All about context, in Europe and at home

The context for the vote will be critical, even if it takes place in an environment where Scotland has elected to remain within the UK (as we expect). One of the factors which will have an impact on the vote is the economic context. While the

referendum is still some years off, at this stage we expect both the UK and Euro area economies to be experiencing a sustained recovery by the time it is held. This would reduce the

possibility of either the absolute or relative performance of the UK economy acting as a drag on a sentiment in a meaningful enough way to increase the chance of voters opting to leave.

5Critics of this view argue that the rejection of the EU’s Lisbon Treaty by Ireland in a referendum in 2008 indicates that voters are prepared to make significant departures from the mainstream on constitutional matters. However, we would argue that this case simply confirms the status-quo bias: voters initially rejected a proposed wholesale change to their relationship with the EU that had been put forward by their national leaders. There is no reason to assume that British voters will behave differently.

6IPSOS-Mori, April, 2014: “Issues Facing Britain,” 992 respondents. The results are consistent with other recent polls

More important, will be the nature of the UK’s relationship with the rest of the region. A referendum is likely to follow years of discussion on the terms of Britain’s membership of the Union. If it has been possible to reach a deal that meets most of the criteria set out by the UK following the balance of

competences review, the government is likely to be able to claim success. These criteria include areas where the UK is likely to make progress, including “competitiveness” in the EU (broadly defined), and areas where it is likely to see significant push-back— likely including its desire to see a “Europe á la carte” where Britain can secure additional opt-outs. An environment in which the government has failed to secure meaningful concessions—as is conceivable—will make the picture much more complex.

For the rest of the region, the British debate on EU exit poses a significant challenge. Most EU leaders have a strong preference for keeping the UK in Europe. A British exit would have a significant impact on the region, creating near-term disruption, rebalancing the region away from market liberalism, and creating an unwelcome precedent. There is thus a strong bias toward helping the UK find a workable long-term solution.

As such, the region is likely to be adaptive; Chancellor Merkel and others have demonstrated a willingness to take some political risks to remain open to UK concerns. However the issue will remain difficult to manage, with a danger that a perception emerges that the UK is “blackmailing” the region (as has been implied in the German press). A slow change in perceptions in Germany could leave a view that it is simply too difficult to keep the UK in the EU, if it were to give the impression that it is not a good faith partner. If handled poorly, the current disagreement on the future leadership of the EU has the potential to create an environment in which the UK has a challenging few years ahead of it—which would not form a positive background to the referendum.

-60 -40 -20 0 20

Bulgaria Estonia Lithuania Malta Belgium Romania Hungary Slovakia Finland Denmark Poland Latvia Luxembourg Sweden Austria Netherlands Slovenia Croatia Czech Ireland Germany France Portugal Italy Greece Spain Britain Cyprus Net positive/negative views on the EU: Member States

British voters dont like the EU very much...

Source: Eurobarometer

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