Cyprus: The Next Blunder

Yves here. Our post today on Cyprus provides some broad background, including the political dynamics and the not-terribly-defensible reasons the Eurozone went that route, and a short discussion of the large risk that this inept move precipitates a wider crisis. This article by Charles Wyplosz serves as a companion, since it discusses the “tax,” um, expropriation option versus other alternatives. Even more important, it sketches out why this scheme, even if it manages not to kick off a crisis, is still inadequate to rescue Cyprus. It is thus a toxic variant of the Eurozone “kick the can down the road” strategy.

By Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva. Cross posted from VoxEU

The Cyprus bailout package contains a tax on bank deposits. This column argues that the tax is a deeply dangerous policy that creates a new situation, more perilous than ever. It is a radical change that potentially undermines a perfectly reasonable deposit guarantee and the euro itself. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors in Spain and Italy.

The decision to tax all Cypriot bank deposits has attracted massive attention (Spiegel 2013) – and rightly so. It is a huge blunder:

• In the unlikely event that all goes well, the government will receive a bit of cash – but not enough to cover the loan generously offered by its European partners – and the Cypriot banking system will be history.

• The alternative is a massive bank crisis in many Eurozone countries – a huge blow to the euro, maybe even a fatal one.

Not an Emergency Measure

Policymakers have been debating the Cyprus’s bailout for nearly a year; this cannot be classified an “emergency action”. They engaged in a lively debate whether Cyprus is “systemic” or not, the answer to which can only be “it depends”. It depends not on the size of Cypriot banks but on the way the Eurozone acts. They also debated the Russian deposits that apparently represent a sizeable proportion of bank liabilities. The debate turned around the issues of how dirty this money is and how to do the laundry. They also debated on the size of a possible loan to the Cypriot government. The government itself requested something to the tune of 100% of its GDP, why not? After all this amounts to 0.2% of Eurozone GDP.

Eurozone’s Help: Suffocating Solidarity

From what is known:

• Cyprus will receive a loan of about half the requested size under the usual austerity conditions.

• The gross public debt of Cyprus will rise from its current level of some 90% of GDP to about 140%, a level that is unsustainable and will eventually require some deep restructuring.

This debt trajectory is a forecast, of course, but well in line with experience.

The effects of this Eurozone austerity programme are now well known. Cyprus joins a distinguished list of countries that benefit from suffocating Eurozone solidarity (Wyplosz, 2011).

• The programme will impose tough austerity;

• Its public-debt-to-GDP ratio will grow because deficits will not go away and because GDP will decline.

• There will the need for more loans as economic predictions will be found to be “disappointing” over and over again.

• Unemployment will skyrocket, spreading intense economic and social suffering.

Who knows, populist parties could well be on the rise, adding political drama to economic pain. This technology is now well oiled.

The Bank Deposit ‘Confiscation’

What is new is that bank deposits will be “taxed”. The proper term is “confiscated”. Like everywhere in the EU, bank deposits in Cyprus are guaranteed up to €100,000. Depositors have arranged their wealth accordingly, only to be told that the guarantee has been changed ex post.

Taxing stocks is optimally time-inconsistent (Kydland and Prescott, 1977). It is a great way of raising money but it has deep incentive effects as it destroys property rights. What is at stake is the credibility of the bank deposit guarantee system throughout Europe.

The system was shaken in 2008 but in the opposite direction. Followed by all other countries, Ireland offered a full guarantee in a successful effort to stem an impending bank run. The cost to the government was such that it triggered a run on the public debt that led to the second bailout after the Greek “unique and exceptional” one.

That move has now been recognised as a mistake, which may explain how Cyprus is now being treated.

The Eurozone’s ‘Corralito’

Because it is time-inconsistent, the decision to tax deposits has been preceded by a freezing of bank deposits. This is remindful of the Argentinean corralito of 2001, which led to economic dislocation, immense suffering and such anger that two governments fell (Cavallo 2011). Hopefully, the Cypriot corralito will not last too long.

The question is: “how bank depositors will react in Cyprus and elsewhere?” The short answer is that we don’t know but we can build scenarios:

• The benign scenario is that depositors in Cypriot banks will accept the tax and keep their remaining money where it is. Depositors in other troubled countries will accept that Cyprus is special and remain unmoved.

• A less benign scenario is that depositors in Cypriot banks come to fear another round of optimal, time-inconsistent levies. This is what theory predicts. After all, if policy makers found it optimal once, why not twice, or more?

Under the less benign scenario:

• We will have a full-fledged bank run as soon as the corralito is lifted. Since bank assets amount to some 900% of GDP, there is no hope of any bailout by the Cypriot government.

• Any new European loan would immediately translate into a run on the public debt.

Enter ECB, Stage Right

At this point in the scenario script, the ECB enters the play. Being the only lender of last resort, the ECB will have to decide what to do.

• In principle, it could stabilise the situation at little cost as total Cypriot bank assets represent less than 0.2% of Eurozone GDP or 0.5% of the central bank’s own balance sheet.

• But this would involve the risk that it could suffer losses – especially if the banks are badly resolved, i.e. the bankruptcies are badly handled.

This is not unlikely since the ECB does not control Cypriot bank resolution.

Remember that the current version of the banking union explicitly leaves resolution authority in national hands. In Cyprus, as almost everywhere else, national authorities are deeply conflicted when it comes to their banking systems. Powerful special interest groups become engaged when banks go bust and governments decide who pays the price. Thus, it is a good bet that Cyprus’s bank resolution will be deeply flawed. The risk to the ECB is real.

Proper resolution under European control could have been part of the conditions for the loan just agreed. But this does not seem be the case. The omission most likely reflects a belief by policymakers that the Cyprus crisis has been solved successfully. The problem is that this belief is false: Cyprus’s predicament remains even under the benign scenario.

All the Conditions for a Total Disaster are in Place

The really worrisome scenario is that the Cypriot bailout becomes euro-systemic – in which case the collapse of the Cypriot economy will be a sideshow. This will happen when and if depositors in troubled countries, say Italy or Spain, take notice of how fellow depositors were treated in Cyprus.

All the ingredients of a self-fulfilling crisis are now in place:

• It will be individually rational to withdraw deposits from local banks to avoid the remote probability of a confiscatory tax.

• As depositors learn what others do and proceed to withdraw funds, a bank run will occur.

• The banking system will collapse, requiring a Cyprus-style programme that will tax whatever is left in deposits, thus justifying the withdrawals.

This would probably be the end of the euro.

Conclusions

The likelihoods of these three scenarios – benign, less benign, and total disaster – are difficult to assess.

• What is clear is that the Cyprus bailout has created a new situation, more perilous than ever before.

• Once more a deeply dangerous policy action is decided apparently without any awareness of its unintended consequences.

It is also another violation of sound existing arrangements. We have a no-bail-out clause in the Maastricht Treaty – a clause that was essential to the Eurozone’s stability. Putting it aside in the case of Greece was the heart of the today’s problem – the reason the crisis spread (Wyplosz 2010). This no-bail-out clause has once again been put aside summarily.

We are now witnessing another radical change as a perfectly reasonable deposit guarantee is being undermined. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors.

See VoxEU for references

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29 comments

  1. Gerard Pierce

    Yves,

    Out of all of this, I get only two pieces of information: `1) Someone is taxing Cypriot bank accounts, and 2) This complete insanity could cause the European banking system to self-destruct.

    Among the things that are not clear:

    Who actually imposed the tax?. Is there a representative government in operation anywhere in this clusterfuck?

    The article speaks of “policymakers” who have been debating the Cyprus’s bailout for nearly a year. Do these policymakers belong to an organization? Do they have a leader who has a name? Are they voted in or appointed?

    This whole thing seems to be a variation of the “mistakes were made” passive voice narrative where the nature of the mistakes and the names of those making the mistakes are conveniently omitted.

    Way back when I played bridge, sometimes we would encounter a hand that was so screwed up that none of us dould do anything with it. This ended with four people speaking in unison: “Who dealt this mess?”

    1. Gerard Pierce

      Appologies. It appears that many of the questions are dealt with the the article “Will Cyprus Become Creditanstalt 2.0” which I had not yet read when I commented here.

  2. the idiot

    Can somebody more enlightened or more astute than I please speculate or provide possible scenarios as to what the “dark political motives behind this move” could be?

    We are now witnessing another radical change as a perfectly reasonable deposit guarantee is being undermined. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors.

    1. change agent

      if one actually follows the money, one wonders what sort of percentage based fee might be payable to the banks holding (and freezing) the deposits as well as the remittance of the tax to the state. Quite a potential windfall for the bankers and friends of bankers.

    2. H. Alexander Ivey

      “more enlightened or more astute” I may not be but I see it as what answer to a basic question: What function does a bank do for the larger community it is in? Does it provide a medium (fiat money provided by the government and credit/debt money provided by itself under the charter of the government) for aiding businesses within that community or does it use this medium as a tool to extract more medium from the said community? Service aid or rent extraction.

      In Europe and many communities world wide, the banks are rent extracting. The political community, which decides which way the banks go – service or extraction, continue to decide for rent extraction.

      As to why the banks go with extraction, that is due to an excessive concentration of wealth into a hands of a relative few. These few, innately conservative, corrupt the politic community to allow their concentration to continue.
      There is nothing natural about any of this, it is entirely under human control.

      1. JohnB

        Well put; that is quite a good way to frame private banking in its current form: Service providing, or rent-seeking?

    3. Bill Smith

      wild stab in the dark:

      troika privately recognizes Apocalypse unavoidable – damage control/creative destruction is backup “non-plan”. periphery has just been FIRED from Eurozone. ECB has enough ammo to save the core with the euro surviving at maybe 80 cents, usd. memo will be issued to investors advising when they may expect to see disorderly restructuring of debt, bonds and equities.

  3. Jim Haygood

    From Bloomberg:

    “If the government wants to change the structure of the solidarity levy for the banking sector, the government can decide as such,” European Central Bank Executive Board member Joerg Asmussen said today in Berlin. “What’s important is that the planned revenue of 5.8 billion euros remain.”

    “It’s up to them to explain it to the Cypriot people,” Schaeuble said … adding that Cyprus faced a “very difficult time” unless it accepts the tax.

    http://www.bloomberg.com/news/2013-03-17/europe-braces-for-renewed-turmoil-as-cyprus-deposit-levy-at-risk.html

    On a per capita basis, €5.8 billion distributed among the 838,000 people in Greek Cypriot territory amounts to €6,921 per capita, or a staggering €19,100 per household.

    Can you imagine how Americans would react to coughing up nearly $25,000 per household for a stability levy?

    This is all being dictated by thuggish-sounding northern Europeans, promising the Cypriots a ‘very difficult time’ (i.e., knee-capping) unless they cough up the loot, pronto.

    Wyplosz’s analogy to the Argentine corralito fits. Now we have unaccountable, Third World-style rule by decree in the heart of Europe, with destruction of legal guarantees dictated by the ostensibly sober-sided rich north.

    If I were a Cypriot, I’d prolly be heaving Molotov cocktails at the Deutschland embassy in Nicosia. Le Boche paiera!

    1. Carla

      Thought I read that uninsured accounts over Euro 100,000, and imagined to be held primarily by Russian oligarchs in Cypriot banks, were to be “taxed” at a rate of 10%, while “insured” accounts of less than Euro 100,000 were to be “taxed” at 6.5%…

      This is still terrible, and as the author of the post points out could have many unforeseen consequences–one of the greatest being that it could be done again, and again. And in other countries.

      However, I think it indicates that the hit to the average Cypriot may not be as high as you have calculated.

      1. Tinky

        “I think it indicates that the hit to the average Cypriot may not be as high as you have calculated.”

        The actual percentage doesn’t matter at all. Their insured savings in a bank account are being confiscated!

        Forest, trees, etc.

      2. Yves Smith Post author

        On the accompanying post, I have a comment which discusses how much $ is estimated to be Russian dirty money. The % seems not to be as high as people imagine. Ilargi says 37%. Another source (Greek) says anywhere from €8 billion to €35 billion euros. One source say Cyprus banks have €152 billion in assets (http://uti.is/2012/12/cyprus-the-fourth-and-final-bailout/), but if you back out foreign bank operations, it’s probably more like €120 billion (she thinks only €92 billion, but again, academic sources have come up with higher %s, so this is all in the stab in the air category, the normal estimate for Cyprus only bank ops as a % of GDP is 7x, not 5x as she has). So 35/120 = 29%, lower than Illargi. If you use €92 billion, you get 35/92, or 38%, which is pretty much Illargi’s #. So let’s use Illargi and treat it as conservative.

        That means the hit per average Cypriot household is still €12,000. Basically, a lot of British retirees live there, and some Russians, not all of whom are necessarily mobsters. So even if you go only after the big deposits, you are still going to whack a lot of hapless folk who were dumb enough to use local banks.

        1. Omerine

          I am listening to the BBC on my local NPR station and someone (a member of the Cypriot parlament) with whom they are discussing this issue said they estimate that 30% of Cyprian deposits are Russian. They also are saying Cypress is now nearly certain to exit the Eurozone. Russia won’t step in to help bail them out because they feel Cypress allows Russian companies to excape taxes. There are approx 150,000 Russian corporates based there to take advantage of the low corporate tax rate.

        2. P. M.

          I posted this comment on Yves post, but worth noting here as well:

          What’s interesting here is that according to chatter on some Russian blogs…many Russians got wind that this was coming in Cyprus and got their cash out early. On some level, it’s reminiscent of what happened when the soviet union fell and ordinary citizens lost their wealth–while those with ties to the government knew and avoided the pain.

      1. R Foreman

        They’d pay a visit to Brussels of course.. “nice car, shame if it suddenly exploded”

        1. Nathanael

          The Russian mobsters are probably working out exactly who was responsible for each of these things and deciding how useful it would be to car-bomb the German Finance Minister (for example).

          On the other hand, they may simply be consulting with Putin.

  4. Me

    What will it take for an old fashioned revolution to remove bastards like this from power? THAT would also set an example. The crook at the ECB should be held accountable for what they have done to the people in the EU.

    1. Nathanael

      See my comment elsewhere. The President of Cyprus has now announced that the banks will be closed until Friday — this is a full seven days of bank closure.

      Somewhere between that and fourteen days of bank closure, people will run out of their cash supplies. And will therefore be unable to buy FOOD. Even if they have money in the bank.

      This might be ameliorated if people’s debit cards are working, or if everyone has credit cards, but “frozen accounts” makes it sound like that’s not the case.

      At that point, when the bank closure prevents people from buying food, THEN people will overthrow the government.

      Cyprus is playing with fire. Either the banks reopen next Monday (or earlier) and the bank run resumes, or the banks don’t reopen and the government is overthrown. I don’t see any other outcomes, unless Cyprus abandons this insane deposit confiscation plan.

      1. Me

        I want, at least, one of these governments to be overthrown and the criminals in power thrown in jail. I would like these bastards to be held accountable. If we lived in a just world the first people in jail would those in charge at the ECB. It would be nice to see some karma done now, in real time. The electoral systems are corrupted by the very interests looting the country. Justice will have to come outside the political system at it is currently constructed. I would love to see some hides here. What these criminal financial parasites have gotten away with will has (already has, for decades. Not only in the EU since the crash. Witness what the “developing” world has paid in debt servicing and how much they still own) death, violence , hunger and poverty. As far as I am concerned, they should have all of that and them some visited upon them. Enough with voting, something more has to be done.

  5. dejavuagain

    Sigh

    Where will the rich Greek plutocrats hide there money now … ???

    Was there not a huge outflow of deposits from Greek banks to Cypriot banks not so long ago …????

    Wonder how many of the deposits in the Cypriot banks are from Cypriots actually living on land on Cyprus for more than 10 nights a year??

  6. briansays

    summed up well by jesse–they have done precisely what will cause that which they said they wished to prevent

    When your money system is based on trust, it is critically important to maintain appearances. Simply reaching out and confiscating the insured savings of depositors is very bad form, especially when everyone knows you are doing it to support a rigged system that is run for the benefit of a fortunate few.

    The sophisticates are fairly used to discussing the darker corners of injustice of the system in their own circles. And they have become comfortable with it, as they are in viewing the victims of their greed as ‘takers.’ I am sure that this played some part in the expedient decision to support the Eurocrony corporatist zone by simply stealing depositors’ money, and deriding them as either crooks or hapless fools who ‘must contribute.’

    But what the cynical plutocrats do not realize is that most people still believe in the system, in rules and justice. And it is this belief that sustains a system based on promises and guarantees and trust.

    I am fairly certain that the financiers and central bankers will wish to shut down any incipient panic in the Euro banks. After all, the entire global reserve currency system is a confidence game.

    Buying the SP futures and selling more paper gold and silver might do the trick. And their talking heads will carry the message that this is much ado about nothing, and merely another buying opportunity.

    They certainly have dipped into that bag of tricks many, many times in the recent past. And personally I will be stunned if they do not make a determined effort to do it again.

  7. Susan the other

    Well, if we look at Latvia, the solution is austerity until 30% of the population migrates. Then the remaining 60% asks for loans to stimulate their dead economy and before that is forthcoming another 10% migrate. So Cyprus will be a ghost island under the EU, or Baku under the Russians. What a nasty choice.

    1. Nathanael

      (southern) Cyprus could also submit to Turkish rule and revive things pretty quickly. Mutual Greek-Turkish racism will probably prevent it, though.

  8. Gerald Muller

    I believe the only possible logic behind this move is to enable Frau Merkel to tell her constituants: “see, I made them cough up and saved your good honestly earned money from bailing out those bastard Greeks and their Russian friends”.
    Don’t forget that a) there is a general election in Germany in September b) a new party called “Alternative für Deutschland” that wants out of the EMU is already credited with 25% of the votes

    1. Nathanael

      “Alternative fuer Deutshland” is capturing votes from the right-wing parties. Die Linke, being the anti-euro party on the left, will capture votes from the left-wing parties.

      The FDP will die by sinking below the 5% threshold.

      It should be an interesting election. It may not be possible to get enough votes for an anti-euro coalition, however; it looks like either the CDU or the SPD will have to be involved in any government. We’re likely to get a horrible SPD/CDU “grand coalition”, with the real blowup happening only after the “grand coalition” screws things up spectacularly.

  9. Jerry

    I don’t need to be in the EU to get the picture…..I get it here in the U.S. Anyone stupid enough to have their money in the banksters in the US cannot complain when that money gets taxed, limits are put on withdrawls, etc. (Oh, and government has their eyes on those retirement funds, IRA, etc. too) ….Currently all Medicare $$$ must go into the Banksters hands before it comes to you, our leaders are in the process of cutting monthly payments….Guess its past time to wake up…It’s here too.

  10. Percy

    I never thought I’d see a nation eliminate its banking industry in a singe stroke. If others were thinking of trying the same thing, none will admit it tomorrow.

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