Friday, 28 October 2016

Brexit, Game Theory, Blair and The Conquistadors

By Richard Ayres

Former PM Tony Blair recently said in an interview that "There's no reason why we should close off any options" suggesting that the UK should not rule out another referendum on Brexit. Let us assume that he sees value in keeping some optionality.

Game theory, however, shows us that there are times when it can be advantageous to close off your options.

The most famous example of this in history comes from the Spanish conquest of Mexico. In 1519 Hernán Cortés landed there with just 600 men, 16 horses and 11 boats. For many years prior, intrepid explorers - far more well equipped that Cortés and his men - had attempted to take control of the Yucatan Peninsula and all had failed at the hands of the Mayans.

Cortés, however, took a different approach. Upon landing he made a very public show of burning his boats. His men now had only one option - to defeat the Mayans or die trying.

While he had reduced his optionality (they no longer had the option to flee) he had actually strengthened his hand. Key to this was clearly signalling this change to his opposition. Game theory is about the interaction between rational decision makers and Montezuma II, the Mayan Ruler, now had only two options - fight (which he would likely win but now at a bloody cost, considering the Spanish had no option but to fight to the death) or accommodate. He chose the latter and set in motion the Spanish conquest of Mexico.

In October the Prime Minister Theresa May declared that she would invoke Article 50 by the end of March 2017. In doing so she strengthened her hand in her battle within her own party - they know that to renege on this would be costly for her, significantly damaging her reputation. She could have kept people guessing and used the time for more planning, but by eliminating that option the dominant strategy of Tory dissenters was now to accommodate - and work with her get the best possible outcome for the UK.

We will likely see this technique again during the Article 50 negotiations. For example, consider the importance of liquidity to financial markets. The EU needs the euro to succeed and has no appetite to weather another financial crisis. However, any settlement with the UK that does not recognise equivalence and mutual rights of access will only fracture liquidity (with London's legal system, language and deep expertise representing a mutually reinforcing set of hard-to-replicate activities).

Over the years, London has built a mutually reinforcing set of hard-to-replicate activities 
UK ministers are now talking of cutting corporation tax rates to 10% if they are unable to reach a suitable deal with the EU. The EU has already expressed discomfort at the thought. The EU banking system cannot afford to see liquidity dry up and their situation would be further exasperated by cutting themselves off from a successful low-tax financial centre on their doorstep.

If the government can turn this into a credible and irrevocable (or at least a costly to reverse) commitment, the EU's dominant strategy moves firmly towards accommodation.

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