The Tempest in Westminster

At issue: regulation of the press. After the recent wave of phone-hacking scandals, intimate photos of royal family members published against their will and other general intrusions of privacy, the UK government launched a full inquiry into newspapers’ illegal behavior and legal enforcement of current privacy and libel laws. Led by Lord Justice Brian Leveson, this was near-universally regarded as a welcome development—certain tabloid newspapers clearly broke the law in many instances, and appropriate punishment and an industry cleanup seemed due.

This, however, is a slippery slope. Sleazy tabloid rags no doubt need a thorough cleansing. But tabloids aren’t ringfenced within print media—all publications are equal in the eyes of the law. Hence the nation waited with baited breath for Leveson’s final report. Would he recommend sweeping regulations that spell the end of Britain’s free press?

Well, the report—all 1,987 pages—is out, and Leveson’s recommendations are pretty darned tough. They include: watering down protection of confidential sources; logging and even recording every meeting (professional and personal) between journalists and members of government, members of parliament, party leaders and lobbyists; a “fair and reasonably complete” summary of all correspondence, text messages and phone calls involving journalists and the aforementioned parties; record and make publicly available all contact between media and senior police officers, effectively abolishing off-the-record meetings; and, most concerning, pass legislation establishing a statutory independent press regulator to monitor newspapers’ behavior and prosecute offenders.

But before you fret the end of journalistic freedom, take heart: Leveson’s recommendations are nonbinding. The government is free to water down or toss them at will. Prime Minister David Cameron said earlier he’d only accept provisions that weren’t “heavy handed” or “bonkers,” and in his address to Parliament after the report’s release, he rejected state regulation of the press. He did support documenting meetings between journalists and sitting politicians and senior police officers, but that was it. On “changes to the Data Protection Act that would reduce the special treatment that journalists are afforded when dealing with personal data,” Cameron said: “We must consider this very carefully—particularly the impact this could have on investigative journalism. While I have only been able to make preliminary investigations about this since reading the report, I am instinctively concerned about this proposal.” And on regulatory legislation, his warning was clear: “We should, I believe, be wary of any legislation that has the potential to infringe free speech and a free press. In this House—which has been a bulwark of democracy for centuries—we should think very, very carefully before crossing this line. ...The danger is that this would create a vehicle for politicians whether today or sometime in the future to impose regulation and obligations on the press.”

Cameron, essentially, would rather establish a new press watchdog independently and have newspapers voluntarily submit to it in order to preserve press freedom. But Cameron and his Conservative Party govern in coalition with the Liberal Democrats, led by Deputy Prime Minister Nick Clegg—and Clegg wants full adoption of Leveson’s recommendations. In what was deemed an “extraordinary step,” Clegg followed Cameron’s statement with his own, averring passing new laws is “the only way to guarantee” newspapers behave. That aligns him squarely with Ed Miliband, leader of the opposition Labour Party.

Ladies and gents, that sound you just heard was the coalition cracking.

Not that the Leveson report must be the current government’s downfall. Cameron has pledged a free vote on the issue, so all members of Parliament can vote their conscience. So if Cameron loses, it shouldn’t call confidence in his leadership into question. Plus, with plenty of Labour backbenchers on Cameron’s side, the Prime Minister has every chance of winning this one. Sure, the coalition could collapse over the issue, but it’s not at all guaranteed.

But the rift between Cameron and Clegg is noteworthy nonetheless. The coalition’s shown signs of wear in recent months as the Conservatives and Liberal Democrats sparred over corporate and income tax cuts, labor market reforms, the UK’s relationship with Europe and the need for fiscal stimulus. The rift widened during September’s party conference season—the UK’s equivalent of the Republican and Democratic national conventions—when Clegg argued in earnest for a wealth tax, something the Conservatives staunchly oppose. The Liberal Democrats have already made some overtures to Labour, eyeing a potential coalition with their more natural ideological ally should both parties secure enough votes at the next election. If Clegg and Miliband cozy up over the Leveson report, the coalition likely only gets more fractious.

For capital markets, a fractured coalition isn’t necessarily bad—the likely resulting gridlock should reduce the probability of extreme legislation and its potential unintended consequences, which is a positive for stocks. However, Parliament’s agenda makes things stickier. Chancellor George Osborne is soon to introduce key banking legislation: regulatory changes based on the Independent Commission on Banking’s (ICB) recommendations and measures enshrining the still-to-be-determined powers of the BOE’s Financial Policy Committee, which assumes banking supervisory duties next year.

When Osborne announced in June the pending regulatory reform legislation would be watered down from the ICB’s recommendation, Clegg wasn’t happy—especially with Osborne’s decision to allow banks’ retail operations to continue marketing derivatives. Two months later, he and Business Secretary Vince Cable pushed to reopen the debate in an effort to secure a full ban on all derivatives trading in retail banking. Osborne demurred, but it’s not over—once the legislation’s introduced, parliamentary debate will likely be contentious, with tensions over the Leveson report only compounding matters.

On one hand, a parliamentary battle over how much to toughen banking regulation might lower the likelihood of any legislation passing—a potential positive, given even Osborne’s watered-down package still included some of the world’s highest capital requirements and forced restructuring of banks’ business models. But the tempest in Westminster would likely also fuel regulatory uncertainty, which could exacerbate existing lending headwinds.

Hence, the parliamentary proceedings over the Leveson report could be as key to the UK’s economic future as its political future. And how they go is anyone’s guess. Miliband has vowed to call a vote on implementation by the end of January, Clegg is still pressing for full implementation, and Cameron isn’t budging. The next several weeks may see a parliamentary rugby match for the ages.