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#BREXIT -- How It Started

Here we are on October 10, with no Brexit deal in sight. Many view the flurry of high level meetings with optimism that a last-minute deal can be found. But as this BCC story today indicates, the European view of the latest UK proposals is far from supportive.

As the clock ticks down to the Brexit deadline this month, many rightly continue to ask “how did we get here?”

The answer is that the Brexit situation has its roots in the Eurozone financial crisis nearly a decade ago. The inflection point was the EU summit in December 2011.

Before migration issues, xenophobia, unicorns, Russian Internet trolls, extremist politicians, trade policy, Northern Ireland, the Withdrawal Agreement, the BackStop, indicative votes, and the customs union dominated the Brexit dynamic, British and EU leaders were locked in opposition regarding governance and sovereignty issues with respect to who exercises what kind of regulation over the euro and the financial system in which the euro trades.

This post tells the story of how and why the EU and the UK are hurtling headlong towards divorce. The craziness that surrounded the referendum result and its aftermath have obscured the deep substantive divisions that were on display in December 2011.

At the time, I was advising large hedge funds and providing macrotrend projection for them. I watched these developments unfold in real time. It was obvious then that the positions being taken would generate dramatic geopolitical shifts.

Scene 1: Prologue

At the time of the December 2011 EU summit in Brussels, the global financial crisis had morphed into a Euro area sovereign debt crisis.

Large banks and sovereign governments across Europe teetered under the weight of non-performing loans and other economic woes. By the time it was all over, five countries (Portugal, Ireland, Spain, Greece, and Cyprus) received bailout packages from the IMF and hastily created European institutions (the EFSF — which morphed into the ESM, the EFSM, and new oversight entities under the umbrella of the ECB). The EU’s common currency survived, but there were days when that outcome was in doubt.

Multiple new treaties were negotiated, signed, ratified, and implemented among Euro area governments at lightening speed. The European Central Bank and EU-level financial regulators acquired significant new authority. The European Commission found itself often sidelined as Euro area governments reclaimed considerable decision-making authority they had previously delegated to Brussels.

While the EuroArea fire brigade was struggling to save the EU, a newly elected British prime minister entered the fray. He collided with a Euro area leadership struggling to save Europe’s common currency, economies, and banking systems. It wasn’t pretty.

As European leaders scrambled to save the euro, they found unity by resisting British policy priorities. Major media outlets (the Economist, the Financial Times, The Telegraph, Euractiv) provided the play-by-play through leaked documents and official statements.

Deep disagreements drove the dramatic discord.

Scene Two: Fiscal Union Dramas

Faced with multiple, simultaneous potential bank and sovereign bond defaults, the Euro area needed a mechanism to funnel financial support to hard-hit economies. but they had a problem. The Maastricht Treaty expressly prohibited “fiscal transfers” within the euro area.

“Fiscal transfers” refers to transmission of taxypayer funds from one sovereign EU Member State to another sovereign EU Member State for the purpose of covering budget deficits, social payments, and bond payment obligations. The idea was to create incentives for all members of the EuroArea to be fiscally responsible (and, implicitly, to follow Germany’s lead in delivering balanced budgets).

If fiscal transfers were illegal, then Member States would know they could not expect their EuroArea sovereign partners to bail them out. Specific economic policy targets (the “Maastricht Criteria” and the “Stability and Growth Pact”) were spelled out in the treaty, creating supposedly binding limits on fiscal policy targets and performance within EuroArea members. The European Commission was empowered to exercise oversight of national fiscal policies.

Obviously, the system failed to operate as hoped.

Heading into the December 2011 summit, leaks to Euractiv indicated that then-EU Council President Herman Van Rompuy would propose a technical solution that would address the fiscal union straight-jacket problem. The idea was ambitious and, in the middle of a major economic meltdown,in retrospect it was unrealistic. He sought constitutional amendments within at least EuroArea Member States (if not all EU Member States). The constitutional amendments would embed the Maastricht economic policy targets into national constitutions rather than seek treaty changes.

In order for that approach to succeed, a unanimous vote was needed at the December 2011 EU summit from all EU Member States. The EU’s need for unanimity seems to have encouraged the UK to negotiate a hard bargain in exchange for delivering political support to the eurozone. At this stage, it is fair to say that at the very least the UK over-played its hand. Less charitable interpretations are possible.

Scene Two: Financial Regulation Dramas

By December 2011, the financial crisis was in its third year. The United States economy had bottomed, finally, but not rebounded. European economies were mostly still in a downward spiral. Weakness in the banking sector (which constitutes roughly 80% of the financial system in Europe) was morphing quickly into a sovereign debt and massive economic problem.

Crisis-driven financial regulation initiatives were in full swing. Policy makers globally had agreed to increase bank capital requirements. Parallel initiatives sought to expand the regulatory perimeter and tighten regulation of central counterparties, SIFIs (systemically important financial institutions), credit rating agencies, significant non-bank financial institutions (like asset managers, including insurance companies), and derivatives markets.

Unlike continental European economies, the UK financial system is dominated by capital markets rather than commercial banks. Financial markets are also the single largest economic sector contributing to the UK’s GDP. This makes financial regulation a strategic, national interest. Traditionally, policymakers both in London and Washington have sought to promote competitive advantages for their markets by issuing regulatory standards exceed global minimum standards.

UK policymakers continued that tradition during the crisis and post-crisis period by seeking to impose “gold plating” requirements on top of those international standards. They maintained that that London as a global financial capital required more stringent standards in certain areas in order to avoid the troubles on display in the Euro area. European policymakers on the continent, unable to increase regulatory capital and other requirements on their ailing banking systems, sought to limit the ability of UK policymakers to exceed international minimum standards.

In addition, continental policy makers led by France sought to impose a “financial transactions tax” on securities markets transactions. Finally, regulators globally were trying to define a framework for cross-border bank resolution. As the Lehman Brothers and AIG situations had illustrated, resolving large, complex, cross-border financial firms can create fiscal policy issues. During 2011, policymakers were still struggling to define a global framework for allocating bailout and/or resolution costs across sovereign borders.

As of October 2019, no agreed international standards exist regarding cross-border resolution. A Single Resolution Board, funded by bank contributions rather than government fiscal resources, was created in Europe to manage cross-border bank closures. The UK is not a member.

Initially, these differences of opinion regarding technical financial services policy did not seem unusual. Civil law countries traditionally prefer to see intermediation through banks rather than through the capital markets favored by common law countries. This drives many conceptual differences regarding how best to preserve and protect financial stability.

Across all these technical financial regulation issues, one constant theme emerged from London policymakers. The UK did not want to incur fiscal liabilities generated by financial instability emanating from abroad. The consequences from the Lehman Brothers failure echoed far beyond the financial crisis. Having refused to bail out Lehman Brothers (an American company) in 2008, UK policymakers had no interest in entering into regulatory or — worse yet — binding treaty obligations to bail out European banks or economies.

Scene Three: The British Demands

Because unanimity was required in order for EU policymakers to move forward, it became quickly clear that the EuroArea would require UK support for the proposed solution. This created a bargaining position for the UK.

British Prime Minister David Cameron arrived at the December 2011 summit primed to protect the UK from Euro area policy priorities. The Telegraph published a leaked document showing that PM Cameron sought a formal UK veto over future EU policies in three areas:

(i) EU regulatory agency authority,

(ii) minimum harmonization provisions that would effectively prohibit UK gold-plating, and

(iii) fiscal measures such as a financial transactions tax or a deposit insurance premium.

These demands placed the UK directly in opposition to a broad range of EuroArea policy priorities. For example, in Bucharest on April 5, French central bank Governor Villeroy de Galhau expressly called for “giving more power to the ESAs (European Supervisory Agencies).

Additionally, Cameron sought to ensure that non-European financial firms currently located in London would permanently be able to access EU markets (“passporting”) even as he sought to exclude UK firms from contributing to European deposit insurance systems. Finally, he challenged European Central Bank policy that would require euro-denominated transactions to be cleared at institutions physically located in the eurozone.

In other words, the UK arrived at the 2011 summit seeking to safeguard UK sovereignty over financial sector policy. Euro area heads of state arrived seeking to save their common currency. Their interests were not aligned.

Scene Four: The Outcome

Summit negotiations collapsed. EuroArea leaders refused to accept the UK demands and the EU refused to compromise.

The Euro area charged ahead. Multiple new European treaties and institutions were created, many outside the EU umbrella, specifically to avoid having to seek compromise and assent from the UK.

The UK sued the European Central Bank at the European Court of Justice — and won — on the issue of location policy for central clearing.

UK-EU relations deteriorated. In a referendum on June 23, 2016, a majority of British voters decided to leave the EU. The British government then triggered Article 50 of the EU’s Lisbon Treaty, which outlines the steps to be taken by a country seeking to leave the bloc voluntarily.

The European Court of Justice ruled in December 2018 that the UK could unilaterally revoke Article 50, thus halting Brexit. Instead, a new Prime Minister (Theresa May) negotiated with the EU in early 2019 a Withdrawal Agreement that was rejected three times by the UK Parliament on the grounds that the proposed deal did not deliver the regulatory and financial sovereignty that formed the foundation for pro-Brexit priorities.

And in between, social media has turbo-charged the news cycle, amplifying extreme views. Allegations of foreign influence, dishonesty, destabilizing economic impacts , and sometimes even treason dominate headlines.

The third Prime Minister holding the Brexit file (Boris Johnson) suspended Parliament — and was reversed by the nation’s highest court.

Most economists agree Brexit will generate economic stress to Europe as well as to the United Kingdom. Concerns regarding global spillover effects are used by central banks to maintain loose monetary policy as a precaution against economic dislocations triggered by Brexit.

Scene Five: The Final Act?

So here we are in October 2019. This week has seen policymakers from the EU and the UK again exchange conflicting letters and bargaining positions. The full chronology for this week can be found HERE.

M. Barnier, the chief EU negotiator released this letter taking a hard line against any renegotiation of the Withdrawal Agreement: “Every issue raised in your letter — from trade in goods to citizens’ rights and data flows — has already been addressed comprehensively in the Withdrawal Agreement. There is no other way to achieve all the benefits that the Withdrawal Agreement provides.”

PM Johnson leaked his letter to the EU stating clearly on page 1: “The Government intends that the future relationship (with the EU) should be based on a Free Trade Agreement in which the UK takes control of it own regulatory affairs and trade policy.”

This week, M. Barnier responded: "We need operational real controls, credible controls, we are talking about the credibility of the single market here - its credulity to consumers, to companies, and to third counties that we have agreements with."


It is difficult to escape the conclusion that policymakers are hurtling towards a no-deal Brexit at the end of October. The economic and geopolitical dislocations associated with this outcome will dominate the geopolitical landscape for the next decade. Tracking the reaction function will be crucial to understanding evolving policy trajectories.


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