The ties that bind the United Kingdom together and the United Kingdom to Europe were strained in last night's election. They could soon break, delivering unprecedented political, economic and market volatility to a country wrestling for a new identity.
As soon as the first exit polls were delivered at 10 p.m. U.K. time, it was apparent the opinion polls had been dead wrong. The election would not be a dead heat between David Cameron's Conservatives and Ed Miliband's Labour Party. Instead, it would prove a crushing defeat for Labour, which only hours earlier had convinced itself it was on the verge of forming the next government with a coalition partner.
Labour got erased from the map in Scotland, where the Scottish National Party (SNP) won almost all of Scotland's 59 seats while the Liberal Democrats, the Conservatives' coalition partner in the last parliament, faced annihilation elsewhere. The Conservatives came on surprisingly strong in the non-Scottish bits of the country and, by dawn, Mr. Cameron was well on course for a second term as prime minister. The only question was whether the Conservatives would win a majority – more than 323 seats in the 650-seat house – meaning they could dispense with a coalition partner and rule as they please.
The results put the U.K. on the edge of momentous changes. It could be not only ripped apart, but also detached from the European Union.
The SNP wants an independent Scotland. Next year, after the Scottish parliament elections, it could promise a second referendum on independence. The Scottish nationalists lost the first referendum, held in September, but by a margin close enough to embolden them. Mr. Cameron promised a referendum on EU membership if re-elected. His plan was to hold the in-out vote in 2017 and it now appears he will do so.
The other major parties oppose a referendum. With the SNP taking Scotland and the Conservatives taking the rest of the country, the bizarre spectre of an independent Scotland remaining inside the EU, and the other remnants of the U.K. outside the EU, is suddenly possible. "The next government has a huge responsibility in facing the very difficult task of keeping our country together," Mr. Miliband said last night, after he won his seat but faced losing the leadership of his party.
Investors' initially applauded the probable Conservative victory. In early trading, the pound surged, gaining as much as 1.7 per cent against the U.S. dollar and 2.2 per cent against the euro, the biggest gain since March, 2009. The FTSE 100 advanced 1.6 per cent to 6,998.41 at 10:07 a.m. in London, rebounding from a one-month low. It climbed as much as 2.2 per cent. Trading volume surged to three times the 30-day average.
Investors, of course, were not blessing the possible break-up of the U.K. or its possible exodus from the EU. They were taking a rather shorter term view. Investors like stable governments and the Conservatives' victory presented that likelihood. They also like conservative governments, which tend to be pro-business and are allergic to tax hikes. In a note published this morning, the London office of Canada's RBC Capital Market said "In the fullness of time…markets might eventually start to worry about the prospect of an EU referendum, and/or a further Scottish referendum, but in the near term [the pound's] rerating probably has further to run."
Even if the Conservatives had not promised a referendum on EU membership and the SNP had not existed, Britain would face dramatic changes under another five years of Conservative rule. That's because they are committed to one of the biggest experiments in shrinking the state that Europe has seen.
The Conservatives campaigned on economic competence, and it worked. They claimed they inherited a wreck of an economy in 2010, two years after the start of the financial crisis and subsequent deep recession that gripped all of Europe, and pulled the U.K. out of the fire through what could be called austerity-lite. To reduce the gaping budget deficit, chancellor of the exchequer George Osborne (who was re-elected) initially cut government spending deeply, then eased up a bit for fear that the cuts would delay the recovery.
Now he promises deep cuts. To eliminate the budget deficit and bring down debt, he is planning spending cuts worth about pounds 30-billion over never next few years, of which pounds 12-billion would be saved from the welfare budget (Labour has pledged spending cuts too, though less aggressive ones). So British austerity is coming, even though austerity has a bad name in Europe, if not in Germany. There is no doubt austerity delayed the wider European recovery and kept Greece, and probably Spain and Italy, in recession longer than should have been.
But investors like austerity, especially the British version, which will rely almost exclusively on spending cuts, not tax hikes. Big Business is generally fond of shrinking states, if only because it boosts their relative power.
What Big Business will not like is the referendum on EU membership, which could lead to Britain's exit – Brexit, as it is called. For the big corporations, the EU is their home market. Their fear is that the tariffs would come back up if Britain were to leave the open market, making trade difficult and expensive. They also fear the political uncertainty in the long and potentially tortuous lead up to a referendum. In an interview in March, Sir Martin Sorrell, CEO of WPP, the world's biggest advertising agency and one of Britain's top employers, said Mr. Cameron, if re-elected, would be wise to hold the referendum next year instead of 2017. "Two years of uncertainty is too much," he said.
ING Financial Markets James Knightley, in a note published this morning, said "The clear risk is that [an EU referendum] could potentially lead to the economy losing some momentum and the Bank of England may raise rates more cautiously."
Today, investors are happy about the Conservatives' election victory. In a year or so, if Britain is gripped in political turmoil, they may take a different view.
Eric Reguly