In the last few weeks, we’ve seen increased talk of a hard Brexit, fostered by comments from British Prime Minister Theresa May. Here are three quick observations from a game theoretical perspective.
First, we are in the very early stages of the pre-negotiation—we’re not even in the negotiation. The negotiation will start only when the United Kingdom triggers Article 50, which is expected to happen in March 2017. The U.K. High Court also just ruled that the government cannot trigger Article 50 on its own, but rather requires parliamentary approval. While Brexit is still likely, the timeline for triggering Article 50 could be in question.
So, we are in the phase where the players are trying to send signals to each other in order to improve their would-be negotiating position. As investors, we should not interpret these signals as necessarily being each player’s actual position.
Second, we should not expect the negotiation to go smoothly.
Players are trying to send signals to each other in order to improve their would-be negotiating position. As investors, we should not interpret these pre-negotiation signals as necessarily being each player’s actual position.
Imagine the difference between negotiating a prenuptial agreement and a divorce settlement. If you push too hard when negotiating a prenup, the consequences could be bad for the marriage. Therefore, the incentive of both players is not to push hard and risk tolerance is limited. But that’s completely different in a divorce settlement.
With Brexit, we are closer to a divorce settlement than to a prenuptial agreement and, therefore, we should expect a bit of tension in those negotiations. But it’s not a complete divorce settlement as the U.K. will still need to trade with the rest of the eurozone.
Finally, this negotiation is going to take a long time. There is a two-year window from the time when the negotiation is triggered and during the negotiation period there is no incentive to make early concessions. Therefore, we expect players to try to run against the end of the negotiation window in order to extract the best possible deal for themselves.
So, while Brexit outcomes will take a long time to unfold, we need to take our time to assess the incentives of the different players in the furors of the negotiation game theater.