UK enters murky waters with hung parliament

After Florida’s election fiasco in November 2000, US political pundits joked that one thing was clear: Ralph Nader (the perennial also-ran) definitely lost the presidential election. What was unclear is whether he lost to Al Gore or George W Bush.

The parallels shouldn’t be exaggerated, but British politics is facing a similar state of electoral disorientation. Last Thursday’s general election brought about a hung parliament at Westminster – something that has not happened since 1974.

The opposition Conservatives finished with 306 seats, gaining 97. The (for now) ruling Labour Party took 258, down 89. And the third party, Liberal Democrats, have 58, down 5, despite an increased share of the popular vote.

Coalition politics and minority governments have a long-established history in both Commonwealth realms (notably New Zealand and Canada) and continental European countries (such as Germany and Italy). But the current generation of British politicians has minimal experience with the back-room manoeuvering that inevitably follows a hung parliament.

Two scenarios

With 326 seats needed for an absolute majority, there are two plausible scenarios. The one that seems most likely for the time being is for the Conservatives to join forces with the Lib Dems, an alliance roughly analogous to Germany’s coalition of centre-right Christian Democrats and libertarian Free Democrats.

This could take the form of either a formal coalition or a minority government with a “confidence and supply” agreement (historical precedents, including 1974, point to the latter option). Indeed, Tory leader David Cameron has been ensconced in negotiations with his Lib Dem counterpart Nick Clegg throughout the weekend, trying to forge a workable compromise that would prove acceptable to both parties.

While Mr Cameron has claimed a mandate to lead the next government by virtue of his party’s parliamentary plurality – a mandate Mr Clegg has implicitly backed by starting talks with him rather than Labour’s Gordon Brown – it is by no means a done deal. The Lib Dems are, at their core, a centre-left party, and many of their members have a stronger aversion to the Tories than Labour.

Thus, there is a possibility that Mr Brown will remain prime minister despite placing second in the election. However, Lib Dem support alone is not enough to keep him at No 10. To get to the magic number of 326, the left-wing nationalist parties must be brought on board too: Scottish Nationalists, Wales’ Plaid Cymru and Northern Ireland’s Social Democrats.

It would be an unwieldy coalition, and a slim one at that, but it would have greater ideological balance than the Tory/Lib Dem alliance.

While the election itself was fought essentially on economic grounds – more on that later – what’s at stake in the cross-party negotiations is nothing less than the UK’s constitutional structure and the future of its party system. The Lib Dems’ defining policy is to introduce proportional representation at Westminster, something that already exists in elections for Scotland’s regional parliament.

Fairness rhetoric

Their push for this policy is couched in the rhetoric of fairness, but of course there is a sizable element of self-interest too: With PR, they would control (using this latest election as an example) 23% of the seats, nearly three times the 8.8% that they will actually have in the new parliament.

Neither of the two major parties, of course, are fans of PR. But Labour under Mr Brown has sounded more amenable to the idea. Mr Brown is offering the Lib Dems a referendum on PR in exchange for their parliamentary support, while Mr Cameron has (thus far, at least) been willing only to create a committee of inquiry to look into the idea. But as cross-party talks continue, Mr Cameron could certainly offer more concessions.

Regardless of which party grouping ultimately takes power, the new government’s most immediate challenge – a proverbial poisoned chalice – will be to sort out the dire fiscal position of the world’s sixth largest economy. How dire?

Well, consider the fact that the Labour government’s latest budget, announced in March, projects a 2010 budget deficit of 11.8% of GDP – roughly on par with Greece, and easily one of the highest levels in the European Union. And although the UK’s current public debt is relatively moderate by European standards at around 70% of GDP – a bit less than Germany, and far below Italy – the real problem is its extraordinary rate of increase.

The 2010 budget projects that the deficit will decline over the next five years to 4.0% of GDP. The favorable economic assumptions underpinning this forecast may, of course, be questionable, but even if the forecast is taken at face value, the fact remains that even by 2015 the UK would still be borrowing more than the maximum 3% of GDP allowed under EU rules.

Currency advantage

Of course, unlike Greece and the other profligate eurozone “PIGS” around the Mediterranean, the UK has retained its own currency. The resulting monetary sovereignty has its advantages: One of the inevitable solutions – if it can be called that – to Whitehall’s persistent overspending is the depreciation of the pound.

The pound has dropped by roughly 25% on a trade-weighted basis since early 2007, when the first signs of the mortgage crisis began to appear. But while the weak pound has supported manufacturing exports, it is also contributing to all-time-high fuel prices in the UK, inevitably stoking concerns about inflation, which the Bank of England is statutorily obligated to keep under 2%.

All this means that the next prime minister and chancellor will have to make a series of painful, unpopular choices about spending cuts, tax hikes, or, most likely, some combination of both.

If Mr Brown were to remain prime minister, he has pledged across-the-board spending cuts starting in 2011 rather than this year, with both health and education exempt from the cuts. On taxes, Labour plans to raise National Insurance by 1%, but combined with several “sweeteners” the goal is to place 60% of the tax increase on the top 5% of taxpayers.

Difficult path

As Leader of the Opposition, Mr Cameron has had to tread a difficult path in trying to address voters’ concerns about the budget deficit without committing his party to a potentially disruptive program of rapid spending cuts. If they take power, the Tories are pledging an “emergency budget” that would impose some cuts immediately, with health being the main exemption.

However, in trying to compete with Labour on taxes from a populist angle, the Tory plan is to limit the National Insurance hike to upper-income taxpayers only – an idea that has won public support from dozens of top employers. They also aim to cut corporation tax from 28% to 25% or even less.

Since the Lib Dems hold the balance of power, they will inevitably hold some sway over the next government’s economic agenda. In general, their fiscal policy has been more closely aligned with Labour’s, with a higher capital gains tax and a “mansion tax” on ultra-luxury homes helping fund lower-income tax cuts, along with deficit reduction.

Regardless of who is at No 10, the Lib Dems could insist on either Mr Clegg or their widely respected shadow chancellor, Vince Cable, taking the Treasury.

Here is one scenario that will most certainly not materialise: A grand coalition of the two main parties. Led by Churchill, such a coalition governed the UK during World War II, but it has not happened since.

In Germany, of course, a grand coalition governed from 2005-09, with Angela Merkel presiding over a cabinet split almost evenly between her Christian Democrats and the opposition Social Democrats. But Germany’s more consensual political system made this a workable possibility.

Furthermore, Ms Merkel herself was not a polarising figure. By contrast, Mr Brown is an intensely unpopular leader, and it is inconceivable that Mr Cameron would agree to work with him – or vice-versa, for that matter. In fact, the strongest argument against Lib Dem support for Labour is the risk of associating themselves with Mr Brown.

Whichever combination of parties leads the UK, the underlying fiscal challenges remain the same, and the range of politically palatable solutions is not especially wide. From the standpoint of the financial markets, therefore, the identity of the next prime minister is less important than confidence that the fiscal crisis will be tackled.

The best-case scenario is a robust recovery that, together with painful but appropriate fiscal reforms, will lead to a substantially balanced budget over the next three to five years. The worst-case scenario? A glance at Europe’s southern flank provides the answer to that question.

Pavel Molchanov is a financial analyst in Texas. Email: pavel@alumni.duke.edu