Posted by greydogg, 99GetSmart
* ALL THE CONDITIONS FOR A TOTAL DISASTER IN PLACE
By Charles Wyplosz, 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 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 program 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 policymakers 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.
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-bailout 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-bailout 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.
Cavallo, Domingo (2011). “Looking at Greece in the Argentinean mirror”, VoxEU, 15 July.
Kydland, F E and E C Prescott (1977), “Rules Rather than Discretion: The Inconsistency of Optimal Plans”, Journal of Political Economy 85(3): 473-491.
Spiegel, Peter (2013). “Cyprus depositors’ fate sealed in Berlin”, FT.com, March 17 6:23 pm.
Wyplosz, Charles (2010). “And now? A dark scenario”, VoxEU.org, 3 May.
Wyplosz, Charles (2011). “The R word”, VoxEU.org, 29 April.[…]
* THE “MUDDLE THROUGH” HAS FAILED: BCG SAYS “THERE MAY BE ONLY PAINFUL WAYS OUT OF THE CRISIS”
By Tyler Durden, zerohedge
Denial. Denial is safe. Comforting. Religiously and relentlessly abused by politicians who don’t want nor can face reality. A word synonymous with “muddle through.” Ah yes, that “muddle through” which so many C-grade economists and pundits believe is the long-term status quo for the US and the world just because it worked for Japan for the past three decades, or, said otherwise, “just because.”
Well, too bad. As the following absolutely must read report, which comes not from some trader of dubious credibility interviewed by BBC, nor even from an impassioned executive from a doomed Italian bank, but from consultancy powerhouse Boston Consulting Group confirms, the “muddle through” is dead.
And now it is time to face the facts. What facts? The facts which state that between household, corporate and government debt, the developed world has $20 trillion in debt over and above the sustainable threshold by the definition of “stable” debt to GDP of 180%. The facts according to which all attempts to eliminate the excess debt have failed, and for now even the Fed’s relentless pursuit of inflating our way out this insurmountable debt load have been for nothing. The facts which state that the only way to resolve the massive debt load is through a global coordinated debt restructuring (which would, among other things, push all global banks into bankruptcy) which, when all is said and done, will have to be funded by the world’s financial asset holders: the middle-and upper-class, which, if BCS is right, have a ~30% one-time tax on all their assets to look forward to as the great mean reversion finally arrives and the world is set back on a viable path. But not before the biggest episode of “transitory” pain, misery and suffering in the history of mankind. Good luck, politicians and holders of financial assets, you will need it because after Denial comes Anger, and only long after does Acceptance finally arrive.
First, let’s recap why BCG thinks all the alternatives have been exhausted …
We believe that some politicians and central banks – in spite of protestations to the contrary – have been trying to solve the crisis by creating sizable inflation, largely because the alternatives are either not attractive or not feasible:
- Austerity – essentially saving and paying back – is probably a recipe for a long, deep recession and social unrest
- Higher growth is unachievable because of unfavorable demographic change and an inherent lack of competitiveness in some countries
- Debt restructuring is out of reach because the banking sectors are not strong enough to absorb losses
- Financial repression (holding interest rates below nominal GDP growth for many years) would be difficult to implement in a low-growth and low-inflation environment […]
* NEWS BRIEFS: CYPRUS
Faced with a growing public backlash, Cypriot finance ministry officials began discussions with lenders on Sunday to lessen the blow for smaller savers.
A source close to the consultations told the Reuters news agency that authorities were hoping to cut the tax band for smaller savers with less than 100,000 euros to three percent from 6.7 percent.
The rate for deposits above that would then be increased to 12.5 percent from 9.9 percent.
The Cyprus Mail reports:
AKEL leader Andros Kyprianou described Cyprus’ treatment by the troika as “vindictive and neo-colonial,” adding that his party would discuss proposing the island’s exit from the eurozone.
“They are attempting to impose their political options on Cyprus, leading out country and people to conditions that are similar to those in other countries of the European south,” Kyprianou said. […]
Demetris Syllouris, the chairman of EVROKO, said the government would not have his support on the matter.
“If they have killed us once it does not matter if they kill us a second time. This is my reaction,” he said.
The Green party suggested that the measures included in the decision did not ensure the salvation of the economy.
“On the contrary, the consequences on common people and workers are expected to be tough, adding to the trials this people is already going through,” the Greens said.
Approval in Cyprus’ fractious 56-member parliament is far from a given: no party has an absolute majority and three parties say outright they will not back the tax. A vote initially planned for Sunday was rescheduled to give more time to build a consensus.
Paul Krugman writes:
OK, I didn’t see that one coming. With all the problems in Greece, Italy, Spain, and Portugal I wasn’t watching Cyprus. But that’s where the big euro news is this weekend; in return for a bailout, Cyprus is supposed to impose a large haircut — that is, loss — on all depositors in its banks.
You can sort of see why they’re doing this: Cyprus is a money haven, especially for the assets of Russian beeznessmen; this means that it has a hugely oversized banking sector (think Iceland) and that a haircut-free bailout would be seen as a bailout, not just of Cyprus, but of Russians of, let’s say, uncertain probity and moral character. (I think it’s interesting that Mohamed El-Erian manages to write about this thing, fairly reasonably, without so much as mentioning the Russian thing.)
The big problem, however, is that it’s not just large foreign deposits that are taking a haircut; the haircut on small domestic deposits is a bit smaller, but still substantial. It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying “time to stage a run on your banks!”
Tomorrow and the days immediately following should be very interesting.
In addition, Tyler Durden @ zerohedge.com has excellent coverage and daily updates on Cyprus.