Game theory is useful when it comes to understanding difficult negotiations. But it is crucial to know what game is being played, and what is at stake.
A decade ago, during the Eurozone crisis, coordination was ensured by unfathomable penalties associated with conflict. The same is not true for Brexit.
As the final weeks of 2020 wind down, the United Kingdom and the European Union remain in tense negotiations about the terms of UK withdrawal from the EU, set in motion by the 2016 ‘Brexit’ referendum. Agreement must be reached by December 31, 2020. Otherwise, a hard Brexit will ensue, harming trade and financial flows between the UK and the EU.
The stakes appear high, explaining why previous deadlines have been ignored. This weekend the chief negotiators pledged to ‘go the extra mile’ to see if an agreement can be struck before year end.
While noting that most financial risks associated with Brexit have been mitigated, the Bank of England (BoE) nevertheless warned this month of ‘volatility and disruption’ in financial markets in the event of hard Brexit. The BoE signaled that it is prepared to step in via large-scale asset purchases to ensure market liquidity and to dampen asset price dislocations. But the central bank may find it more difficult to address counter-party risk if cross-border financial contracts are not honored from January 1, 2021, as BoE has noted could be the case.
The projected economic costs of a non-deal outcome are significant. According to one study, the EU could lose over $35bn in annual exports, with German, Dutch and French firms hit hardest. UK exports could fall by double-digits, inducing a 2021 recession on top of an already Covid-19 ravaged economy. A jump in import costs stemming from higher tariffs, non-tariff barriers and a steep sterling decline would undermine the purchasing power of UK firms and households.
Longer-run economic costs could also be substantial. Studies suggest the UK economy is already 2.5% smaller as a result of Brexit uncertainty. Other research indicates the long-term impact of reduced trade and investment could leave Britain’s economy as much as 6-10% smaller by 2030 than would be the case if the UK remains in a free trade zone with the EU.
Given the economic and financial costs of a hard Brexit, many observers anticipate a last-minute compromise. Financial markets are also sanguine. The best Brexit barometer—the value of the UK pound sterling versus the euro—has softened in recent weeks, but sterling still remains above its lowest levels this year.
Market participants and other observers may be taking comfort from the past, namely the last-minute deals that rescued the Eurozone at the apex of its crises from 2010 to 2012. But that’s not the right template for Brexit. Crashing out is more likely today than back then.
First, Eurozone countries in 2010 understood that they shared a currency and a central bank. Despite tough and acrimonious negotiations over deficits, debts and structural reforms, the euro proved a powerful inducement to compromise. Leaving a common currency area would have imposed draconian default and inflation costs on countries such as Greece. Abiding a deal, on the other hand, held out the promise—fulfilled in 2012—that the European Central Bank (ECB) would ‘do whatever it takes’ to ensure orderly financial conditions and low interest rates to facilitate adjustment.
Yes, a hard Brexit will make UK residents worse off. Yet it would not lead to the same degree of financial instability and economic chaos that leaving the Eurozone would have imposed on Greece, Italy, Portugal or any other ‘peripheral’ countries. The losses associated with Brexit might be high, but they are not catastrophic.
From the EU perspective, hard Brexit is also child’s play compared to Eurozone breakup. Had Greece plunged out of the Eurozone, widespread public and private sector default would have ensued. Germany and other northern European countries would have had to write down massive debts, requiring a huge taxpayer-financed recapitalization of their banks. Greece’s leaving would have also raised the risk of other countries departing, imposing even more astronomical costs on creditor countries. The unravelling of the Eurozone was an anathema to debtor and creditor alike. It was to be avoided at all costs.
The same is not true for Brexit, even a hard variant. Losses will ensue, but they are a fraction of what would have occurred in a Eurozone breakup.
Brexit also differs in its political and historical dimensions. No matter how aggrieved Greeks, Italians, Spaniards or Portuguese felt about heavy-handed German demands during the Eurozone crisis, they shared a common history, one that holds Europe together in ways unfamiliar to British thinking. Two thousand years of European civil war has tempered continental views on the ultimate legitimacy of national sovereignty. Many of today’s citizens of Greece, Spain and Portugal also have first-hand recall of how the EU offered them a path from postwar dictatorship to democracy.
Britain’s proud heritage of democracy and defender of freedom—separate from Europe—makes Brexit discussions, which at root are about sovereignty, fundamentally different. The Eurozone crisis posed existential threats to European livelihoods and ideals in ways that Brexit does not, for either Europe or Britain. If anything, Brexit manifests the cultural, historical and identity gaps between Britain and Europe.
Returning to game theory, the Eurozone crisis was a profound prisoner’s dilemma. If either side failed to coordinate, the result would be disastrous for both. Compromise was therefore the logical and highly likely outcome, even if the terms were asymmetric and imposed massive economic costs on the ‘periphery’.
In Brexit, trade-offs for both sides are more difficult to judge. The economics may be clear, but the perceived losses fall far short of what is required to readily accept other costs, such as loss of sovereignty. In the absence of extreme outcomes, few societies make decisions based solely, or even primarily, on economists’ estimates or forecasts.
Rather, other questions become more relevant.
What price is a British government and its citizens willing to pay to (re)-claim sovereignty? What are the costs the EU is willing to accept to avoid compromising principles that it demands of its own members to participate in the world’s largest free trade zone? What risk is the EU willing to take that other recalcitrant members might follow the UK out, if the costs of exit are low?
Put differently, Brexit is less a prisoner’s dilemma than a game of dare, where each side challenges the other to a race to the cliff’s edge, knowing that an icy river (but not certain death) lies below.
Lastly, what are investors to make of this?
In the Eurozone crisis, markets were roiled by last-minute negotiating brinksmanship. In hindsight, it is easy to see the markets’ reactions as expressing fears of a low probability, yet calamitous, outcome. In contrast, ahead of the final, year-end Brexit deadline, markets are relatively calm. It is difficult to say whether investor passivity reflects belief that one side will capitulate, or anticipation that only modest economic and financial dislocations will ensue in the event no agreement is reached.
But holding those two beliefs simultaneously is incongruous. A breakthrough, sadly, is only likely if at least one side fears the consequences of failure. That’s the fulcrum of the Brexit game.
Today’s market passivity, therefore, stretches credibility. We should not be surprised if the pound comes under pressure in global foreign exchange markets before year end.