Brexit and the real meaning of uncertainty

In the enabling legislation establishing the EU referendum, consistent with its party’s manifesto at the 2015 General Election, the Conservative Government set the date for a referendum on continued EU membership as “prior to the end of 2017.” The Party’s manifesto was published in April 2015; the enabling legislation for the referendum received Royal Assent in December 2015.

After returning from his negotiations in Brussels to attempt to secure ‘a better deal’ on Britain’s membership of the EU, on 20 February 2016 Prime Minister David Cameron announced the date for the ‘in/out’ referendum. Two days later, the measure was introduced to and debated in the House of Commons. The referendum was set for 23 June, four months hence. It had been foreshadowed, formally, for 14 months. No-one can claim they couldn’t see the vote coming; the outcome, of course, appears to have been a different story.

Within government and without, preparations seem to have been, well . . . largely non-existent. A marked exception to this is the Bank of England. On the morning following the vote, the Governor, Mark Carney, stated emphatically:

it will take some time for the United Kingdom to establish new relationships with Europe and the rest of the world. Some market and economic volatility can be expected as this process unfolds. But we are well prepared for this.  The Treasury and the Bank of England have engaged in extensive contingency planning and the Chancellor and I have been in close contact, including through the night and this morning. The Bank will not hesitate to take additional measures as required as those markets adjust and the UK economy moves forward.

And take additional measures they have, reducing reserve capital requirements on banks, notionally freeing an additional £150 billion on banks’ balance sheets for lending. In March, Dr Carney warned that the referendum was the biggest near-term domestic risk to financial stability. On 5 July, he stated “Some of those risks have begun to crystallize.” Why?

It seems that the Bank of England was pretty much the only part of Government with a plan. Within the Cabinet Office, it appears planning for exit was verboten. In late February 2016, the BBC reported that the Cabinet Secretary, Sir Jeremy Heywood, had stated that

civil servants and special advisers should not give ministers campaigning for the UK to leave the EU access to government papers, apart from ones they have already seen, on the referendum or David Cameron’s EU renegotiations.

However, the ban was not even-handed, at least according to political website Guido Fawkes, which quoted Heywood’s letter as saying:

The principles of impartiality and the proper use of public resources continue to apply to all government communications activity, including activity related to the EU referendum.

Extraordinary. In such circumstances, it would have been impertinent, not to mention impossible, for the senior Leave campaigners to prepare meaningfully for an exit. It was for the Government to make such preparations. But none of this explains why the Cabinet Office, itself, had not prepared for an exit.

In the wake of the Leave vote, the pound has dropped over 13% to a 31 year low. Far more materially, major ratings agencies have downgraded the UK’s credit rating, with Standard & Poor’s lowering the rating two notches from AAA to AA and reducing the UK’s debt below investment grade – material for holdings by major US pension funds.

More worryingly, following the Leave vote, YouGov’s Business Confidence index fell from 112.6 to 105.0 – thus, still positive. Over the same period, YouGov’s Economy Optimism index fell from 105.1 to 86.8 suggesting business decision-makers polled were, in YouGov’s words, “in a state of shock” and expected deteriorating economic conditions; indices for domestic sales, exports and capital investment expectations all fell sharply. As YouGov stated:

The share of businesses that are pessimistic about the economic outlook over the next 12 months doubled from 25% to 49% in the course of a week.

The readiness of UK business for the exit vote is debatable. In mid-April, the Chartered Institute of Internal Auditors reported that a survey of their members in FTSE 250 companies showed that only 21% had made contingency plans for an exit. The CIIA’s press statement continues:

The survey also found that 10% of the FTSE 250 Heads of Internal Audit said that they had no intention of making any contingency plans for a British withdrawal from the EU. 62% said that they planned to do so, but that it was not yet possible, due to uncertainty.

Presumably, this is the very same uncertainty that necessitates the contingency plans in the first place.

But here we strike the nub of the problem. In 1937 (rather embarrassingly, in the Galton Lecture to the Eugenics Society), John Keynes stated:

The idea of the future being different from the present is so repugnant to our conventional modes of thought and behaviour that we, most of us, offer a great resistance to acting on it in practice.

Never have Keynes’s words rung more true.

But the picture is complex. A significant fall in the sterling should improve export competitiveness, suggesting the falls in the export expectations may be unjustified. The impact of the fall of the sterling on real estate values, influential on confidence in the domestic economy, is harder to foresee.

At its heart, the problem is that UK businesses do not distinguish conceptually or analytically between uncertainty and risk. The future is ineluctably uncertain; no calculation can change that uncertainty. The uncertainty over the future of the EU is as great and no greater than the uncertainty over the future of UK institutions; both are uncertain by virtue of being in the future. By assigning perceived or historically observed probabilities, we can arrive at different levels of estimated risk. However, this approach is not without material assumptions, as Keynes – here discussing Bentham’s approach to cardinal utility – notes earlier in the same article quoted above:

. . . so that multiplying together the numbers attached to all the possible consequences of a given action and adding the results, we could discover what to do. In this way a mythical system of probable knowledge was employed to reduce the future to the same calculable status as the present. No one has ever acted on this theory.

Yet this is precisely how the most common approaches to corporate risk analysis – other than mere guesswork – are supposed to work. Faced with the uncertainty around definition and estimation of the variables involved, few will have bothered, beyond reviewing their currency risk exposure and, now, their bond and interest rate exposures.

The simple truth is that it would not have been possible or meaningful for businesses to prepare substantially before the vote; there are simply too many imponderables, too many moving parts. Firms can understand their strategic and financial exposures to a range of plausible outcomes and timeframes and monitor progress, little more; planning, as it is usually understood, would be futile.

The time over which the Conservative Party’s selection of a successor to Mr Cameron will play out offers a breathing space to understand the appropriate approach to notifying the EU of the UK’s intention to withdraw and to gauge the reaction of the European Council and Commission to the impending withdrawal. That will be crucial to the UK’s negotiating strategy with the EU following Article 50 (2) notification and following Brexit two years later, beyond which negotiations are almost certain to continue. It will also provide a window during which businesses can refine their expectations over the future state and adjust their strategies to the new trading, economic and political realities.

What will prove far more significant is the vision a new Conservative Party leader and Prime Minister of the UK will hold and can enunciate and initiate for a UK operating independently from the EU in world trade, international relations and diplomacy, reform of international institutions and international security. The vision that emerges will impact policy areas from defence to international development to agriculture to tax to education to welfare and health. At such a pivotal moment, vision and leadership are essential. What will that vision be and what consistent domestic reforms will it necessitate?

An electorate unaccustomed to hearing the case for the need for reform will not be easy to persuade. Such is the chalice the new Conservative Party leader will inherit.


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