4 reasons investors should worry about the “federalisation” of Britain

A Pandora’s box of long-festering issues is unpicking the country’s unity and constitutional settlement. How can the conflicting demands of the Scots, Northern Ireland and the failing regions be balanced?  It seems inevitable that this will involve a deepening of what is effectively the “federalisation” of its constituent nations and economic balkanization of England’s regions. Break up is unlikely but the political resolution will be at best a compromise.

In the short term, expect frenetic activity as the government promises debt-funded excess and future white-elephants. Expect a divergent UK as regions and nations vie with each other and for central government largess.

What is uncertain, is the country's long term trajectory.

Despite the UK government’s propaganda, the Pandora’s box of tensions and issues unlocked by Brexit have not magically gone away. Investors are right to worry about what this means for the future of the UK. Some form of deeper federalisation of the constituent nations of the UK and an economic balkanization of England proper seems inevitable.  

For investors, these trends have implications for UK debt of all kinds, the long term stability of the country’s credit rating, the economics of regional projects, attractiveness of London, and the impact of an increasingly politicised and interventionist bureaucracy. 

Such change need not be dramatic. England has a long tradition of accomplishing radical realignments without the tromp of boots.  In the 18th Century, parliament managed it by engineering an invited invasion into the bloodless Glorious Revolution – at least, if you were English. A Revolution, to quote Professor Kenneth Morgan, that bookmarked one end of the “period in which Britain rose to a dominant position among European trading empires, and became the first western nation to industrialise.” 

Brexit, a creature of domestic English politics, has highlighted and exacerbated the differences in the aspirations of the UK’s other constituent nations. With such clear evidence of Westminster’s disregard for Scottish sentiment, it will be difficult to contain separatist tendencies in the current devolved settlement.

Within England proper, regional productivity needs to improve but this will not happen while failing areas are subsidised by the success of London. With the centre of political gravity apparently moving to the north, will London continue to be so quiescent in funding these ungrateful regions?  

Changes like localisation of revenue from business rates point the way to how regions and authorities could be incentivised. They also point to the political impossibility of this.  

More likely, there will be further regional fiscal devolution, a bureaucracy energised to dabble in industrial policy and an orgy of investment in regional projects funded by debt and at the expense of London. 

These are ideal conditions for politically connected investors, industrial white elephants, and nimble investors with regional knowledge.

Four conflicting factors make this a difficult balancing act:

The Irish question

Buying-off Unionist angst will demand even more money

Despite all the protestation, the reality is that in solving the Brexit issue, Boris has thrown the Northern Irish loyalists overboard. It seems inevitable that an internal border in the Irish sea will change the relative ease of doing business on the island as compared to mainland Britain.  

Given Boris’s character, it would not be unreasonable for Loyalists to wonder about the long term agenda. Perhaps the solution to Britain’s troublesome Irish problem is to encourage economic integration and then watch as the natural flow of trade and demographics leads to its reunion with the Irish Republic? It would certainly save some ￡9 billion in subsidies to the region and have the irony of handing the problem to the EU.

The DUP are only the latest to show that Northern Irish politicians are adept at extracting large sums of money. If the Government is to head-off Unionist angst, then even more money and preferential treatment will be required for the region.

The Scottish question

The Scots are right to distrust the power of Westminster unmoderated by EU institutions - will money be enough this time?

Surveys suggest that the Scots are being dragged from the EU against their will. They are right to view this as being imposed on them by English voters and to distrust the power of Westminster unmoderated by EU institutions. 

The Scots can rightly ask why the Northern Irish were treated differently. The Northern Irish will benefit from being half-way in each union. There is no denying that a powerful reason behind that difference, is the fear of a return to military action in English cities. 

As Indyref1 showed, the Scots are also adept at using constitutional tension to extract concessions and money from Westminster. Other than oil, there are powerful reasons for the English to continue to pay-off the Scots to remain as the unitary military power on the island of Great Britain.  

Last time, these financial concessions did not play well with English constituencies and only increased the calls for England to have its own parliament, separate from the Westminster parliament of the union. Such a move would make the country a federation in all but name.

Current efforts to stonewall Scottish demands for independence run the risk of inflaming the situation. Already, many of the comments have the resonance of those speaking about conquered territories rather than fellow members of a union. 

A constitutional confrontation is all but inevitable. This time the “shake-down” may not be satisfied with just tweaking the Barnett Formula to put more money in the hands of the Scottish government. A more formal constitutional solution seems the only way to save some semblance of the union.  

An energised Scotland in both unions, like Northern Ireland, would certainly be an interesting development.

Divergent regions and nations

No longer one-nation but an island of "regions and nations"

The language of public discourse often tells us a lot about the thinking of the political class. The glossing over of regional differences has been replaced by politicians’ self-conscious claims to represent “one-nation” and, most telling, the media’s “new” language of an island of “regions and nations”.

Between them, London and the south-east subsidise the other regions around ￡60 billion per annum. If this is to change, there needs to be some combination of improving regional productivity, reduced services or declining living standards for budgets to match. As it is, if an area falls behind, it relies on London's success to subsidise its population and services through welfare and central government funding.

There must be an incentive for cities and regions outside London and the south-east to perform. This will not happen if London continues to subsidise the rest of the country. Achieving this would inevitably mean more devolution of spending and revenue retention. The likelihood is this will involve painful adjustments.

Last week’s announcement of the initial results of the Fair Funding Review initiated by Theresa May points to the practical and political difficulties of this. The review aimed to give new funding baselines as local authorities prepare for a change in business rates which will see 100% of the tax retained in the area rather than being passed to the central government. 

Even this small realignment will see relatively wealthy southern areas such as Hampshire (+￡35m) and Surrey (+￡26m) gaining with big losses in places like Birmingham (down ￡48m), Liverpool (down ￡16.2m) and Manchester (down ￡10.4m).  

This is politically difficult for a Tory party that wants to embrace northern, working-class voters who blame others for their problems.  Even more so, given Tory-controlled Hampshire and Surrey cover the constituencies of 11 Tory MPs including cabinet members Dominic Raab and Michael Gove while Birmingham, Liverpool and Manchester are historically big Labour city strongholds.

In many ways, today’s issues are simply a continuation of the age-old tensions between the different waves of people who have occupied this island and the divergent economies of each region.

It seems politically impossible to fully address the country’s internal imbalances. More likely, we will see a return to policy-driven industrial projects as the government attempts to drive up the regions. If history is a guide, an orgy of debt-fuelled investment in regional projects that more often than not will prove to be white elephants.

The tilt north

The regions blame London for their failings but beggaring London is not the solution

If the UK’s new government is to be believed, we are witnessing a seismic shift in the UK's political centre of gravity. The Tories are already planning to move their HQ north; most likely to Manchester. There are also early plans for the Lords to be relocated to York.

It has always appeared as if there is a political pact that London has the dominant position in the country’s political life in return for paying for the rest of the country. This is something that predates modern times to when English kings located themselves at the Palace of Westminster to be close to the wealth of the City of London and its troublesome citizens. This historic pact clearly seems to be shattering.

Like it or not, the regions rely on London to pay the bills. With 13% of the population, it generates 25% of the country’s GDP. Transfers from the taxes collected in London subsidise the social welfare and public services in all but two of the other regions in the country.

It has become fashionable to blame London for the failings of the regions. As one commentator in The Times recently put it, “The Brexit years have cemented in the national mind: not only that some parts of the nation have been “left behind” but that they have suffered in order for London to succeed”. 

Beggaring London will not solve the country’s issues but it will reduce the attractiveness of London and the nation’s wealth.

Leaving the EU against the wishes of the vast majority of London’s population will most likely exacerbate the apparent unfairness of paying for the ungrateful regions while being politically eviscerated.

If London were to retain more of its money, then perhaps this is the grand political bargain that will sustain London’s competitiveness and compensate it for the loss of political influence and the losses that Brexit will inflict. 

However, achieving this will either deepen the regional divide or bankrupt the state.