Brexit Games

by | December 14, 2020

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.

Here’s why.

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.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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