The latest deal about Cyprus was a good reminder that nothing has yet been fixed in Europe and nothing has been learnt about the origins and nature of the euro crisis. While the deal still remains sketchy three whole weeks after the initial agreement, the analysis of what went wrong in Cyprus remains sketchy too.
Cyprus has been one of the newest members of the euro area. Soon after adopting the euro in 2008, Cyprus found itself with a deteriorating fiscal position, as did every country in the eurozone due to the global crisis but nonetheless saw its international competitiveness improving. The country’s problems came about from the overreliance of the economy on banking services for growth, a pattern quite common in island economies which for geographical reasons cannot develop a sizeable industrial base. As the banking sector grew, so did its exposure to Greece, its most important trading partner. Eventually it faced collapse after investing heavily in the safest asset class of all – government bonds. The spark for the country’s banking crisis was the restructuring of the Greek Government debt in 2012, with a domestic housing bubble contributing to a lesser extent.
A banking crisis of this magnitude which wipes out the entire capital base of the country’s banks can only be managed in four possible ways: a) letting depositors take a hit, b) calling in the State to the rescue, c) using fiscal stimulus and/or d) by inflation. By far the most common practice around the world is a combination of options (c) and (d) but in a manner that is not clearly visible.
The existence of fiscal transfers on the one hand makes banking crises less frequent and less severe, because when borrowers encounter financial hardship they tend to increase their state benefits intake while reducing tax contributions. When these automatic stabilizers are not enough to stem a banking crisis and a consequent recession, the government can provide a stimulus to the economy, running a budget deficit and thus creating new money. Lastly, the central bank can also act by devaluing (inflating) the currency, if the FX market has not done so already. These automatic or routine crisis-fighting measures contain banking crises and spread losses across taxpayers, depositors and fixed income investors at the benefit of borrowers.
This combination of options could however not be used in the case of Cyprus due to the euro’s handicaps, leaving only two options available: a depositors’ bail-in or a State bailout.
Considering the public outrage with the continuous bailouts of failing banks by the taxpayers, a solution that involves depositors in the recapitalization of the banks seems fair. After all, depositors provide funding to the banks, they receive interest on those deposits and therefore should also bear the associated risks. The rationale of this solution is sound as it is based on the principles of the modern free market.
This logic however ignores the market fragmentation in the euro banking system and the dual role that the banking system plays in an economy. Banks do not just provide the system with financial intermediation. They also provide a utility service that for practical reasons foreign lenders cannot provide. Households and SMEs can only rely on the domestic banking sector to maintain saving and payment accounts as well as for their short term funding. They are also ill equipped to conduct a professional assessment of the credit risk profile of their bank. And lastly, small economies like the one of Cyprus do not have sufficiently developed capital markets and banks need to serve as the main financial intermediaries. Therefore in a market for financial services like this, principles of free market cannot be blindly adopted exactly because the market is not truly free.
Since working with principles is not Europe’s forte anyway, an ad hoc approach to the case of Cyprus could indeed be considered. This ad hoc approach should aim to protect the economy of Cyprus, and not to destroy it. Using all uninsured deposits in a bail-in solution has caused a liquidity crunch which pushed several businesses immediately to bankruptcy. The systemic consequences of this deal for the economy of Cyprus were not at all considered, showing that the handling of the euro crisis was based on other priorities.
The Clique that rules the eurozone had realized that the only way to protect its own interests was to let depositors bear all losses. We could imagine that the decision making process around the deal in its basic form looked like this: first, an exposure limit was established for the bailout. Considering the size of the Cypriot economy, its systemic importance and the relative political weight of the country in European affairs, an unnegotiable limit of 10 bn (approximately 50% of the country’s GDP) was established. The 10 bn would however be an acceptable exposure only if the country did not incur any more debt, and therefore a recapitalization of the Cypriot banks by the Cypriot state was immediately ruled out. Under these constraints, the Cypriot government was then given all freedom to choose how to deal with any capital shortfall. It could hurt secured and unsecured depositors alike risking a public outrage, or it could hit the unsecured depositors to the extent that its business model would be destroyed. That was hardly the range of options that the Cypriot government would like to have to face, but it still gave the illusion of choice and control of the Cypriot government over its affairs.
This plan required then a story that would justify to the public why Cyprus has to suffer and why the eurozone would not protect one of its weakest members. The necessary smokescreen was easy to find in the revelations about obscure Russian oligarchs laundering money on the island, the tax haven characterizations, the insolvency of the country’s banks and the unsustainability of its business model. These excuses cannot be taken seriously after a closer scrutiny.
First of all, Russian deposits however large they still represent a minority of the deposit base of the Cypriot banks, and from those deposits a large part comes from legitimate business. In fact, we have no hard evidence yet of any money laundering activities taking place in Cyprus, so the case could very well turn into a fiasco (remember the WMD in Iraq?). And besides that, Europe should be much more concerned about the Europeans’ laundry businesses and leave the Russian laundry business to be dealt by the Russians. The deal for Cyprus could aim to protect Cypriot businesses from going bust overnight and ordinary folk from losing their savings, tackling any money laundering issues at a later stage, in a controlled fashion that would only hit the wrongdoers.
Secondly, the tax haven status was not a consideration at all when Ireland requested a bailout, and the country was not required to make any amends on its corporate tax policies, unlike Cyprus. Of course private interests in keeping the low tax rates in Ireland were much stronger than those in Cyprus. And perhaps we should not forget that every country is still able to formulate its own fiscal policy and cater it to its specific needs. A country as remote as Cyprus may find it sensible to charge lower corporate tax rates in order to attract more business on its soil and support employment. Actually, most countries in the world provide such tax incentives for businesses established in remote, undeveloped areas.
The rest of the talk has been even more ridiculous. The Irish banks were and still are terribly insolvent, just like the Greek and the Spanish banks for reasons I have explained in my previous description of TARGET2. That has not stopped the Eurosystem from funding them through an ELA facility, but then again Cyprus is not as systemically important as the other countries so why should it be granted a similar treatment, right?
And lastly the talk about the unsustainability of the business model of Cyprus should cause laughter to everyone, especially when coming from German officials. The Cypriot business model with its huge banking sector might have been risky indeed, but it was not in any way more unsustainable than that of Germany, which is based on lending money to foreign countries so that they can afford German exports while at the same time competing with them, a business model that relies exclusively on the country’s ability to run structural balance of payments surpluses. Unfortunately a more careful analysis is required to understand what is hidden behind the apparition of the German economy’s resilience and mainstream media cannot dare go that far.
But the media were unable to critically assess some other parts of the deal anyway. The part that was most controversial but has attracted no attention at all in the media is the fact that the ECB and the Central Bank of Cyprus (CBC) did not suffer any losses from the deal. Even in the wound down Laiki Bank (CPB) the ELA was transferred to the “saved” Bank of Cyprus. The CBC and the ECB in the context of the deal could easily be left with the collateral that they received through their refinancing operations. The collateral would most certainly be worth less than the amounts loaned, so the Eurosystem would shoulder its own fair share of the losses at the benefit of the other depositors. The case made a complete mockery of the principle of allocating the losses where they “really are” and revealed the paranoid existence of the Eurosystem. While every central bank in the world aims to protect the value of its currency and by extension the value of the deposits, the Eurosystem preferred to deliberately destroy them.
By the completion of this deal, the Clique has managed to protect all its interests. Cyprus was kept in the eurozone; the eurozone and the IMF will provide the country a small, serviceable loan and earn a decent carry; the eurozone’s systemically important banks will not be affected; the core will pick up some of the banking business that Cyprus will lose and possibly more from other national banking systems that will need to shrink; and the Eurosystem will not suffer any humiliating losses. All losses are fully internalized in the Cypriot economy that is sacrificed in the altar of the euro’s “irreversibility”. It was a great plan, greatly executed.
But what should be done then? It is easy for an anonymous blogger like me to criticize these decisions, but after all this critique, what would be the solution that I would propose?
In my view, the problem of Cyprus is the existence of the problem itself. If the euro was not a flawed currency and the eurozone’s monetary system was solid, Greece would not have had to restructure its debt and most probably it wouldn’t have accumulated it in the first place. And if Cyprus was not in the eurozone it would have dealt with any potential banking crisis with a mild devaluation, just like any other country would do. The exposure of the Cypriot banks to Greek debt (denominated in a foreign currency) would also have been smaller.
So instead of having a discussion on whether one solution was better than another, analysts would do better analyzing why this problem occurred in the first place, why countries outside of the euro would be better able to cope with it if it ever occurred, why we are confronted with problems that have no fair solutions and why we still do not have a systemic approach to avert or deal with these problems in the euro area.
When a systemic and fair solution to the euro crisis is missing, one that is based on economic reasoning and principles and not the discretion of the elite, the problems that the euro area is going to face will only have bad solutions which will keep worsening as the rot continues to spread. The Clique is well aware of that but for as long as the situation gives them the opportunity to deal with each case individually, it will not give up its unique powers to shape the European economy and society in any way satisfies its interests.
It is at least ironic that Russian “oligarchs” have taken such a center stage in a crisis that showed yet again how the true oligarchy of the Clique has seized power over eurozone’s governance and why it chooses to maintain the status quo. This was a great opportunity to take away that power from the Clique and it is a great misfortune that the opportunity was lost. We now have to wait a little longer for the next one.