Brexit 101: All You Wanted to Know but were Afraid to Ask


Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.

On June 23rd 2016, the United Kingdom of Great Britain voted to leave the European Union. In the era of Twitter tags, this event has come to be known as Brexit. David Cameron, the prime minister of Great Britain, resigned very soon after the result was announced.

The financial markets have been freaking out since then.  The question is what is Brexit all about and why are people worried about it. Before answering this, it is important to go back into history and understand the context that led to the formation of the European Union.

What led to the formation of the European Union?
The origins of the European Union can be traced to the European Coal and Steel Community (ECSC) and the European Economic Community (EEC) formed by six countries (which were France, West Germany, Italy and the three Benelux countries i.e. Belgium, Netherlands and Luxemburg) in 1958.

The goal of ECSC was to create a common market for coal and steel in Europe. The EEC on the other hand worked towards advancing economic integration in Europe. The economic integration of Europe was deemed to be necessary by many experts to create some sort of bond between different countries in a continent destroyed by extreme forms of nationalism during the Second World War.

The Second World War had lasted from 1939 to 1945 and had more or less destroyed the European countries. Hence, the idea was that if economic integration happened, peace would automatically prevail.

When was the European Union formed?

These organizations (i.e. ECSC and EEC) gradually evolved into the European Union (EU) which was established by the Maastricht Treaty signed on December 9 and 10, 1991. The creation of a single European currency became an objective of the EEC in 1969, but nothing happened for the next two decades. It was only in the 1993, after the formation of the European Union by the passage of the Maastricht Treaty, that the members became bound to start a monetary union by January 1, 1999.

Currently, there are 28 countries which form the European Union. Further, there are 19 countries which use the euro as their currency (i.e. monetary union). The United Kingdom of Great Britain is not a part of the monetary union within the European Union. It has its own currency (i.e. the pound).

What were the advantages of the European Union?

The basic idea behind European Union was economic integration that led to peace. Let’s take the case of a company which makes cars in the United Kingdom. Before the European Union came into place, if the company wanted to sell its cars in Spain, it would have had to pay a tariff in Spain. (Not surprisingly, the British car companies were against the country leaving the European Union).

Or let’s consider someone British who wanted to work and enjoy the literary scene in Paris. Before the European Union came into place, he would have had to go through a long immigration process.

The European Union essentially did away with these problems and made the movement of both goods and people across the countries which became members, much easier than it was in the past.

So what happened in Great Britain?               

On June 23, 2016, the citizens of the United Kingdom of Great Britain voted 52:48 to leave the European Union. This wasn’t expected. Both opinion polls as well as experts had been predicting that Britain would vote to stay in the European Union. But as is the case more -often than not, experts and opinion polls turned out be wrong.

Around half of Great Britain’s exports currently go to the European Union. At the same time around half of Great Britain’s imports come from the European Union[i]. Around one-third of Great Britain’s financial services exports are to the European Union. At the same time, more than half of the cross border lending that the banks of Great Britain carry out is to the European Union. Further, Great Britain receives half of its foreign direct investment from the European Union[ii].

In the days to come all this will have to be renegotiated with the European Union. It is estimated that negotiations will have to be carried out with 60 non Euro Union countries where trade as of now is governed by European Union rules[iii].

So why did Britain leave the European Union?

Given such strong trade as well as financial linkages, why did Britain leave the European Union? The major reason being now offered is that immigration is now a major issue in Britain. Given that, English is the second language of many Europeans, and the main language in Britain, it was easy for the continent based Europeans to move to work to Britain than vice versa.

The other reason being offered is that many of the people who voted for Britain leaving the European Union, did not understand that voting for Britain leaving the European Union, actually meant that Britain would have to leave the union. As dumb as it sounds, there are several news reports which have offered this theory along with examples.

The thing with reasons is that they can also be offered after the event has happened. Hindsight bias plays a huge role here. Hence, I don’t think it is very important to understand why Britain has left the European Union. It is more important to understand how this will play out from here.

What happens now?

It needs to be mentioned here that Britain’s vote to leave the European Union is not legally binding. The British Parliament still needs to pass the laws which will repeal the laws that got Britain into the European Union. This will have to start with the 1972, European Communities Act[iv].

Further, the British leadership (David Cameron or his successor) will have to invoke Article 50 of the Lisbon Treaty. This will start the process formal legal process for Britain to get out of the European Union. At the same time, it will give them two years to negotiate the withdrawal.

Why is the world freaking out?

It is clear that Great Britain has a lot to lose by getting out of the European Union. But why is everyone else worried? The simple reason is that calls are now being made in other European nations, including Spain and France, to get out of the European Union. While, no one knows, how this will play out, if anything along these lines happens, it is likely to jeopardise the entire idea of an integrated Europe. If this were to happen, the future of the euro as a currency would be put to test. Also, if anything like this materializes, it will be next Lehman Brothers kind of moment.

One result of this will be that the European Union will be fairly aggressive in its negotiations with Great Britain (like it was with Greece). It will try and send out the message that any sort of dissent will not be tolerated[v]. This will be done so that message is carried over to any other country that is thinking about leaving the European Union.

Further, calls are now being made in Scotland, for a referendum to leave the Great Britain. In fact, the Scots as a whole have voted to stay in the European Union. If Great Britain decides to get out of the European Union, then Scots want to have their own referendum to get out of Great Britain, in order to stay in the European Union. So the disintegration of Great Britain is also a possibility now.

What about the financial markets?

The basic point is that financial markets hate any sort of uncertainty. And there is simply too much uncertainty surrounding the Brexit issue right now. Also, this has reinvigorated, the dollar as the safe haven trade all over again. This has led to money going out from all parts of the world and into the United States. This explains other currencies losing value against the dollar.

Further, as Nomura Research points out in a research note: “This extreme uncertainty in the City of London, one of the world’s largest financial centres, is anathema to global financial markets, especially when the global economy is as fragile as it is and as there are limited monetary and fiscal policy easing buffers available to most of the world’s major economies.”

Also, Brexit has thrown up the rising risk of Donald Trump winning the elections in the United States, scheduled in November 2016. As Anatole Kaletsky writes in a Project Syndicate column: “The “Brexit” referendum is part of a global phenomenon: populist revolts against established political parties, predominantly by older, poorer, or less-educated voters angry enough to tear down existing institutions and defy “establishment” politicians and economic experts.” And that has really got the financial markets worried.

The column originally appeared in the Vivek Kaul’s Diary on June 28, 2016


[i] Doug Criss, The non Brits guide to Brexit, CNN, June 20, 2016

[ii] Brexit: Expect waves of contagion on Asia, Nomura Research, June 24, 2016

[iii] Nomura Research

[iv] Brian Wheeler & Alex Hunt, The UK’s EU referendum: All you need to know, BBC, June 24, 2016

[v] Ben Hunt, “Waiting for Humpty Dumpty”, Epsilon Theory, June 23, 2016

Greece is now a political crisis not just an economic one


Last week Greece was bailed out for the third time. The total bailout amounts to 82-86 billion euros. In order to access this money the Greek government has to follow a series of austerity measures like pension reforms, implementing the highest rate of value added tax for business sectors which currently pay a lower rate, etc.
Before the bailout was announced many economists were of the view that Greece should leave the Eurozone. Eurozone is essentially a term used to refer to countries which use the euro as their currency.
The logic offered by these economists is fairly straightforward: Greece needs to get out of the euro and start using its own currency, the drachma. In this situation, the drachma would fall in value against other currencies and in the process make the Greek exports competitive. This would help revive Greek exports as well as tourism, and in turn the Greek economy.
The austerity measures that Greece has had to follow since 2010, when it was first bailed out, have crippled the Greek economy. The economy has contracted by 25%. The unemployment is at 26%. Among youth it is over 50%. Small and medium businesses are shutting down by the dozen.
The government debt as a proportion of the gross domestic product (GDP) has jumped from 126.9% in 2009 to 175% currently. This has happened primarily because the size of the Greek economy has contracted leading to the total amount of debt as a proportion of the GDP(which is a measure of the size of an economy) shooting up.
If Greece leaves the euro and moves to the drachma, it will be in a position to devalue the drachma and in the process hope to revive its economy. This is something that it cannot do currently given that it uses the euro as its currency.
The economists who have been calling for Greece to leave the euro are looking at the situation just from an economic point of view. What they forget is that euro has political origins.
The euro came into being on January 1, 1999. But it took a long time for the countries which originally started to use the euro as their currency to get there. A brief history is in order.
Before the euro came the European Union. The origins of the European Union can be traced to the European Coal and Steel Community (ECSC) and the European Economic Community (EEC) formed by six countries (which were France, West Germany, Italy and the three Benelux countries i.e. Belgium, Netherlands and Luxemburg) in 1958.
The goal of ECSC was to create a common market for coal and steel in Europe. The EEC on the other hand worked towards advancing economic integration in Europe. The economic integration of Europe was deemed to be necessary by many experts to create some sort of bond between different countries in a continent destroyed by extreme forms of nationalism during the Second World War.
As the Nobel Prize winning American economist Milton Friedman wrote in a 1997 column: “The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe.”
The EEC and the ECSC organisations gradually evolved into the European Union (EU) which was established by the Maastricht Treaty signed on December 9 and 10, 1991. After the formation of the EU by the passage of the Maastricht Treaty, the members became bound to start a monetary union by January 1, 1999.
What this tells us loud and clear is that the euro was as much a political project as it was an economic one. Given this, asking Greece to leave the euro, is not an easy decision to make politically, as it goes against the basic idea of the United States of Europe. As long as the European politicians are serious about this basic idea, Greece will continue to stay in the Eurozone.
The issue has taken another political dimension with the United States (US) of America getting involved. The US isn’t directly involved but as is often the case, it is operating through the International Monetary Fund (IMF).
On July 14, 2015, the IMF released a four- page report in which it said that the Greek public debt is unsustainable. Public debt is essentially government debt minus government debt that is held by the various institutions of the government.
As the IMF report pointed out: “Greece’s public debt has become highly unsustainable…Greece’s debt can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far.”
The IMF wants Europe to handle the Greece issue with more care. “There are several options. If Europe prefers to again provide debt relief through maturity extension, there would have to be a very dramatic extension with grace periods of, say, 30 years on the entire stock of European debt, including new assistance… Other options include explicit annual transfers to the Greek budget or deep upfront haircuts,” the IMF report points out.
Basically there are three things that the IMF wants. First, it feels Greece should be allowed more time to repay the debt that it owes to the economic troika of IMF, European Central Bank and European Commission. The IMF wants to give Greece a 30 year moratorium on its debt.
Third, it wants Europe to help Greece more by giving more money to the country ever year. And fourth, it wants lenders of Greece to take a haircut, which basically means that they should let Greece default on a part of the debt that it has taken on.
The question is why are the Americans doing this? A simple explanation for this is that if Greece is abandoned by Europe it could approach China or Russia for help. And this is something that the Americans won’t be comfortable with. A television analyst used to making flippant statements could even call it the start of the second Cold War.
The trouble is that IMF released this report after the third bailout of Greece had been announced. As Albert Edwards of Societe Generale put it: “I simply do not understand why the IMF did not come out loud and clear…and say they would not participate in this charade without debt forgiveness.”
The mess in Eurozone just got messier.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column appeared in the Daily News and Analysis on July 21, 2015

How deflation can spoil the global stock market rally

stock-chart Vivek Kaul  
There are stock market rallies that are currently on across various parts of the world. The stock market rally in the United States is now nearly 5 years old, having started in March 2009. But there is a small factor that investors who are driving up these markets are not taking into account. And that is the current low inflation scenario as well as the prospect of deflation.
As Gavyn Davies writes in The Financial Times “The vast majority of developed countries are currently reporting a headline inflation rate of below 1.5 per cent, with the trend in virtually all of them headed downward.”
Inflation in the Euro area (17 countries in Europe which use the euro as their currency) for the month of December 2013 stood at 0.8%. In December 2012 it had stood at 2.2%. The inflation in the European Union (which includes the euro area countries plus 11 more European countries) was at 1% in December 2013. It was at 2.3% in December 2012.
A similar trend seems to be playing out in the United States. For the month of November 2013, the consumer prices, as measured by the personal consumption expenditures deflator, rose by 0.9%. 
This number was at 1.7% in November 2012. The personal consumption expenditures deflator is a measure of inflation favoured by the Federal Reserve of United States, the American central bank. The Federal Reserve has an inflation target of 2%. Hence, to that extent consumer prices in the United States are rising at a much slower pace than the target favoured by the Federal Reserve.
As Davies writes “It is hard to remember a period, other than in the months immediately following the financial crash in 2008, when…headline inflation has been so low in so many different economies.”
And why is that a worry? 
Lets look at the European Union inflation data in a little more detail. Countries like Greece, Cyprus, Latvia and Bulgaria are facing deflation. This means that prices in these countries are falling. In other countries like Sweden, Spain, Italy, France and Portugal, the rates of inflation are less than 1%. In fact, in case of Spain and Portugal these rates are close to 0%.
When prices are falling or it looks like that they will soon start falling, consumers tend to postpone their consumption decisions in the hope of getting a better deal in the future. This has an impact on businesses, and, in turn, the economy in general.
When consumers postpone their buying, businesses try to attract them by cutting prices of their products. This means a loss of revenue and a further fall in the rate of inflation. And this might lead to consumers postponing their consumption even further. So the loop works.
Once countries get into what is known as a deflationary spiral, it is very difficult for them to get out. Japan is an excellent example of the same. The country has been trying to come out of a low inflation/deflation kind of scenario for close to two decades now, without much success.
Investors across the world have chosen to ignore this threat which has been lurking around the corner for a while now. As Albert Edwards of Society Generale writes in a research note titled Markets still refuse to price in deflation threat….. for now dated January 15, 2014, “Investors have yet to react to the deflationary threat however. They do not seem to care that they are sitting on the edge of a cliff. Markets remain stoic about the risks of outright deflation in the US and eurozone for one very simple reason – they simply do not believe a recession that would trigger outright deflation is on the horizon. Quite the reverse – they believe with all their heart that we are at the start of a self-sustained recovery. That is despite the fact that the US recovery is already noticeably longer than average, and that the classic signs of old age, such as rapidly slowing productivity growth and stagnant corporate profits, can clearly be seen.”
A reason for the confidence of the stock market investors is the fact that over the last few years, at the slightest sign of trouble, central banks around the world have printed money (or what they like to call quantitative easing or QE) to keep interest rates low. This has allowed investors to borrow at rock bottom interest rates and invest in financial markets throughout the world. And that will keep the stock market rallies going. As Edwards puts it “Because the market has firmly got it into its head that QE will 
always be good news for equities. So if the economy swoons, equities will look through any short-term disappointment as more QE will save the day. Investors see bad economic news as good news for equities.”
Hence, investors expect central banks to print more money once they start feeling that deflation is a serious threat to their economies. And the logic is that a lot of this money fill find its way into the stock market and drive prices higher. But there is a problem with this logic.
Until 2012, every time central banks cranked up the printing press, prices of commodities like gold rallied. But that hasn’t happened in the recent past, even though central banks continue to print money. Hence, the proposition that central banks printing money will lead to stock markets rallying, may not always hold true.
As Edwards puts it “I do believe this to be utter nonsense. For in the same way as investors believe, axiomatically that QE will drive up equity prices, they believed exactly the same thing of commodities until 2012. Commodities are a risk asset and benefited massively from QE1 and QE2, so why has QE3 had absolutely no effect on commodity prices? Exactly the same thing could happen to equities if a recession unfolds and profits plunge at the same time as the printing presses are running full pelt. Do not assume equities MUST benefit from QE.”
And this can really spoil the global stock market party. I had asked the well respected financial historian Russell Napier, who works for CLSA,
 in an October 2012 interview I did for the Daily News and Analysis, that by what level does he see the stock markets falling in the coming deflationary shock. And he had replied “I will just go back to my book Anatomy of the Bear, which was published in 2005 and in the book I forecasted that the equity market, the S&P 500 (an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points [On Thursday, January 16, 2014, the S&P 500 closed at 1,845.89]. As you know, in March 2009 it got to 666 points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400.”
And once the S&P 500 starts to crash, the rest of the world will follow. Of course, till that happens, there is money to be made.
The article originally appeared on on January 17, 2014 

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Cyprus’ financial repression: when people bail out govts

Vivek Kaul 

John Maynard Keynes (pictured above) was a rare economist whose books sold well even among the common public. The only exception to this was his magnum opus, The General Theory of Employment, Interest and Money, which was published towards the end of 1936.
In this book Keynes discussed the paradox of thrift or saving. What Keynes said was that when it comes to thrift or saving, the economics of the individual differed from the economics of the system as a whole. An individual saving more by cutting down on expenditure made tremendous sense. But when a society as a whole starts to save more then there is a problem. This is primarily because what is expenditure for one person is income for someone else. Hence when expenditures start to go down, incomes start to go down, which leads to a further reduction in expenditure and so the cycle continues. In this way the aggregate demand of a society as a whole falls which slows down economic growth.
This Keynes felt went a long way in explaining the real cause behind The Great Depression which started sometime in 1929. After the stock market crash in late October 1929, people’s perception of the future changed and this led them to cutting down on their expenditure, which slowed down different economies all over the world.
As per Keynes, the way out of this situation was for someone to spend more. The best way out was the government spending more money, and becoming the “
spender of the last resort”. Also it did not matter if the government ended up running a fiscal deficit doing so. Fiscal deficit is the difference between what the government earns and what it spends.
What Keynes said in the General Theory was largely ignored initially. Gradually what Keynes had suggested started playing out on its own in different parts of the world.
Adolf Hitler had put 100,000 construction workers for the construction of Autobahn, a nationally coordinated motorway system in Germany, which was supposed to have no speed limits. Hitler first came to power in 1934. By 1936, the Germany economy was chugging along nicely having recovered from the devastating slump and unemployment
. Italy and Japan had also worked along similar lines.
Very soon Britain would end up doing what Keynes had been recommending. The rise of Hitler led to a situation where Britain had to build massive defence capabilities in a very short period of time. The Prime Minister Neville Chamberlain was in no position to raise taxes to finance the defence expenditure. What he did was instead borrow money from the public and by the time the Second World War started in 1939, the British fiscal deficit was already projected to be around £1billion or around 25% of the national income. The deficit spending which started to happen even before the Second World War started led to the British economy booming.
This evidence left very little doubt in the minds of politicians, budding economists and people around the world that the economy worked like Keynes said it did. Keynesianism became the economic philosophy of the world.
Lest we come to the conclusion that Keynes was an advocate of government’s running fiscal deficits all the time, it needs to be clarified that his stated position was far from that. What Keynes believed in was that on an average the government budget should be balanced. This meant that during years of prosperity the governments should run budget surpluses. But when the environment was recessionary and things were not looking good, governments should spend more than what they earn and even run a fiscal deficit.
The politicians over the decades just took one part of Keynes’ argument and ran with it. The belief in running deficits in bad times became permanently etched in their minds. In the meanwhile they forgot that Keynes had also wanted them to run surpluses during good times. So they ran deficits even in good times. The expenditure of the government was always more than its income.
Thus, governments all over the world have run fiscal deficits over the years. This has been largely financed by borrowing money. With all this borrowing governments, at least in the developed world, have ended up with huge debts to repay. What has added to the trouble is the financial crisis which started in late 2008. In the aftermath of the crisis, governments have gone back to Keynes and increased their expenditure considerably in the hope of reviving their moribund economies.
In fact the increase in expenditure has been so huge that its not been possible to meet all of it through borrowing money. So several governments have got their respective central banks to buy the bonds they issue in order to finance their fiscal deficit. Central banks buy these bonds by simply printing money.
All this money printing has led to the Federal Reserve of United States expanding its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank(ECB) has expanded its balance sheet by around 98%. The ECB is the central bank of the seventeen countries which use the euro as their currency. Countries using the euro as their currency are in total referred to as the euro zone.
The ECB and the euro zone have been rather subdued in their money printing operations. In fact, when one of the member countries Cyprus was given a bailout of € 10 billion (or around $13billion), a couple of days back, it was asked to partly finance the deal by seizing deposits of over €100,000 in its second largest bank, the Laiki Bank. This move is expected to generate €4.2 billion. The remaining money is expected to come from privatisation and tax increases, over a period of time.
It would have been simpler to just print and handover the money to Cyprus, rather than seizing deposits and creating insecurities in the minds of depositors all over the Euro Zone.
Spain, another member of the Euro Zone, seems to be working along similar lines. L
oans given to real estate developers and construction companies by Spanish banks amount to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. And hence Spanish banks are in big trouble.
The government is not bailing out the Spanish banks totally by handing them freshly printed money or by pumping in borrowed money, as has been the case globally, over the last few years. It has asked the shareholders and bondholders of the five nationalised banks in the country, to share the cost of restructuring.
The modus operandi being resorted to in Cyprus and Spain can be termed as an extreme form of financial repression. Russell Napier, a consultant with CLSA, defines this term as “There is a thing called financial repression which is effectively forcing people to lend money to the…government.” In case of Cyprus and Spain the government has simply decided to seize the money from the depositors/shareholders/bondholders in order to fund itself. If the government had not done so, it would have had to borrow more money and increase its already burgeoning level of debt.
In effect the citizens of these countries are bailing out the governments. In case of Cyprus this may not be totally true, given that it is widely held that a significant portion of deposit holders with more than 
€100,000 in the Cyprian bank accounts are held by Russians laundering their black money.
But the broader point is that governments in the Euro Zone are coming around to the idea of financial repression where citizens of these countries will effectively bailout their troubled governments and banks.
Financing expenditure by money printing which has been the trend in other parts of the world hasn’t caught on as much in continental Europe. There are historical reasons for the same which go back to Germany and the way it was in the aftermath of the First World War.
The government was printing huge amounts of money to meet its expenditure. And this in turn led to very high inflation or hyperinflation as it is called, as this new money chased the same amount of goods and services. A kilo of butter cost ended up costing 250 billion marks and a kilo of bacon 180 billion marks. Interest rates as high as 22% per day were deemed to be legally fair.
Inflation in Germany at its peak touched a 1000 million %. This led to people losing faith in the politicians of the day, which in turn led to the rise of Adolf Hitler, the Second World War and the division of Germany.
Due to this historical reason, Germany has never come around to the idea of printing money to finance expenditure. And this to some extent has kept the total Euro Zone in control(given that Germany is the biggest economy in the zone) when it comes to printing money at the same rate as other governments in the world are. It has also led to the current policy of financial repression where the savings of the citizens of the country are forcefully being used to finance its government and rescue its banks.
The question is will the United States get around to the idea of financial repression and force its citizens to finance the government by either forcing them to buy bonds issued by the government or by simply seizing their savings, as is happening in Europe.
Currently the United States seems happy printing money to meet its expenditure. The trouble with printing too much money is that one day it does lead to inflation as more and more money chases the same number of goods, leading to higher prices. But that inflation is still to be seen.
As Nicholas NassimTaleb puts it in 
Anti Fragile “central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.”
It is when this inflation appears that the United States is likely to resort to financial repression and force its citizens to fund the government. As Russell Napier of CLSA told this writer in an interview I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries.” Treasuries are the bonds that the American government sells to finance its fiscal deficit.
“May you live in interesting times,” goes the old Chinese curse. These surely are interesting times.
The article originally appeared on on March 27,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)