On 7 May the United Kingdom will hold the closest election since, well, the last election. The result is widely expected to be a ‘hung’ Parliament: neither the Conservatives nor the Labour Party will emerge with enough seats to control a majority. Although both parties are currently (4 May) projected to receive roughly 34 percent of the votes, the Conservative should come out with a five seat lead when these votes are translated into Members of Parliament. That gap is too small for the Conservatives to form a coalition government with the Liberal Democrats, even relying on the support of the Northern Irish Democratic Unionist Party. It is too large for the Labour Party to form a minority government with the support of the Scottish Nationalists. By implication, either the Liberal Democrats will have to lend their support to Labour, or Labour will have to vote with the Conservatives to dissolve the Parliament with new elections to be held in October. Of course these projects could change by election time. The calculus of possibilities would obviously change along with it. In a close election like this one, even small differences can have a big impact in terms of outcome.
This is where the economic implications of the contest become important. Investors hoping to peer through the veil of the future can do little better than consolidate their positions and hold their breath. You can see the short-term impact in the data for exchange rates and implied market volatility. The exchange rate data shows investors consolidating their position in the immediate run up to the contest. In the last week, the pound sterling has dropped against both the dollar and the euro. Go back a month and the picture looks very different because currency movements were dominated by the divergence between the euro (which weakened before strengthening) and the dollar (which strengthened before weakening). The pound was caught in the middle, rising against the euro while falling against the dollar or the reverse. Now investors seem to care more about what is happening in UK polling booths than in U.S. or European central banks. The problem is that they do not know what to make of the different possibilities. This is where the volatility indicators become important. The Financial Times (FT) reported on 4 May that the implied volatility index has ‘jumped up 17.8 percent’.
There is a lot to be concerned about. Although the macroeconomic statistics for the UK look pretty good in terms of growth and unemployment, there are worrying trends beneath the surface. As FT columnist Martin Wolf complains, productivity growth is very low in the UK which suggests both that employment is underutilized and that the prospects for real wage increases are slim. Such analysis is consistent with the high levels of income inequality observed both across British society and from one part of the country to the next. Britons are working more and the economy is producing more but they are not getting a good return on their effort and the division of the spoils is more likely to reinforce that pattern than to reverse it. The state of public finances is not much better. Data for longer term trends in public sector finances from the Office of National Statistics shows that the British government is still running large government deficits after more than five years of austerity and even once public investment is subtracted from expenditure. The level of public debt is growing faster than the national economy as a consequence. Hence we should expect any future government to have to continue with fiscal consolidation even though this will constitute a drag on macroeconomic performance. Then there is the situation regarding export competitiveness. The UK is running massive current account deficits, fuelled by the poor performance of manufacturing exports. Hence global demand is unlikely to boost UK performance. On the contrary, long-term inflows of foreign capital in specific segments of UK property markets is exacerbating the inequality in the distribution of wealth (in addition to income) and threatening to produce another round of asset bubbles.
In other words, the UK is facing big problems in terms of its economic structure, public finances, and savings-investment balance. Unfortunately, the major parties show little interest in addressing these concerns. Instead they have focused the campaign broadly on questions of ‘economic competence’ and narrowly on specific sectors of public services, like health care and education. Moreover, the economic platforms across potential coalition or support partners do not add up. The Conservatives would have to forge a compromise between the Liberal Democrats to their left and the Democratic Unionists to their right; the Labour Party would have to forge a compromise between the Liberal Democrats to their right and the Scottish Nationalists to their left. This makes it hard to anticipate just what kind of economic program would emerge from the negotiations. It is equally hard to anticipate what a caretaker cabinet would do over the next several months should Labour and the Conservatives agree to dissolve parliament.
Then there is the question of Britain’s relationship with Europe. This issue has figured less prominently in the debate than foreign observers might imagine. That is due in part to the fact that the UK Independence Party (UKIP) will struggle to win more than a handful of seats. For all its bluff and bluster, UKIP’s support is too diffuse to have more than a marginal impact within the British electoral system. It can pull specific Conservative candidates to the right, but it cannot frame the debate in the same way it influenced conversations during the last elections to the European Parliament. On a deeper level, however, Europe is not so much in the debate because British elites have gravitated toward a diffuse and pervasive Euroskepticism. The Conservatives insist on holding and in-or-out referendum before 2017. The Liberal Democrats are willing to concede that point in order to achieve ‘more important’ domestic objectives. The Labour Party has rejected calls for a referendum but admits that it will need to hold an in-or-out vote if there is any more transfer of authority to Brussels. And the Scottish Nationalists are saving fire for the constitutional debate that will reignite when Scotland elects is Parliament in 2016.
What this suggests for an international observer is that Britain’s relationship with Europe will change no matter who comes into power. It also suggests a further evolution in England’s relationship with Scotland. The challenge is to anticipate the direction, scope, and pace of movement across these two dimensions. That challenge is too great to tackle on the basis of the information currently available; hence it is far easier simply to defer investment. This adds another drag on growth and employment - which, in turn, is a good reason to consolidate exposure to the UK and to avoid the increasing volatility of ever thinner markets. The political outcome of the elections is highly uncertain; the economic outcome is not. Britain is headed into a very close contest and British macroeconomic performance will suffer as a consequence.
Erik Jones, SAIS Johns Hopkins University