This post was published on the Bruegel blog and on Peterson Institute RealTime, and republished by Vox.
The late Mike
Mussa of the Peterson Institute, a former Chief Economist of the
International Monetary Fund (IMF), noted about some episodes of the late-1990s
Asian financial turmoil that “there are three types of financial crises: crises
of liquidity, crises of solvency, and crises of stupidity.” This quip comes to
mind when considering the developments of the past few days around Cyprus.
The March 16 announcement of an agreement
backed by most European leaders and institutions as well as the IMF, which called
for a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank
deposits, no matter how small, was a policy blunder likely to cost the European
Union (EU) dearly.
The sequence that led to this “Saturday-morning plan” is
well known. Greece’s sovereign debt restructuring a year ago hit Cypriot banks
that had bought Greek bonds, raising doubts about the Cypriot government’s own
solvency. Negotiations on a possible bailout by the EU had been seen as
inevitable as early as mid-2012. But discussions were frozen until a general
election in Cyprus last month. Unfortunately, the delay pushed the timetable of
negotiation into German election cycle territory, constraining the latitude of the
euro group, in which Germany is now the unquestioned central actor. Driven by the
domestic German political debate, European negotiators were intent on forcing
losses on large (read Russia-linked) Cypriot deposits as an indispensable
component of the package.
To the surprise of many, the recently elected Cypriot
president, Nicos Anastasiades, added a further twist to the tangled situation
by suggesting a hit to small depositors as well. According to some reports, he
wanted to limit the losses imposed on large depositors in order to preserve the
island’s future as an international financial center. All negotiators seem to
have accepted this offer before realizing, too late, how damaging it might be
to trust in the safety of bank deposits well beyond Cyprus.
No easy or painless option was available for Cyprus.
However, some of the Saturday-morning plan’s flaws were avoidable.
First, the plan disregarded the lessons of financial history
about the high importance of deposit safety, particularly for middle-class
households (which is why there usually is an upper limit for explicit deposit
insurance, harmonized at € 100,000 in the EU since 2009). Based on the
experience of the early 1930s, it is virtually undisputed in the US that a
breach of deposit insurance will primarily hurt the “little guys.” Sheila Bair,
the respected former Chairman of the US Federal Deposit Insurance Corporation,
has expressed
this view with reference to Cyprus. Similar lessons arise from the record of many
recent emerging-market crises.
If it is true, as alleged, that Cyprus’s own president was
the one who recommended hurting small depositors, European negotiators were not
justified in going along. After all, in November 2010 the Troika of the EU, the
European Central Bank (ECB) and the IMF rebuffed the Irish authorities’
proposal to “burn” the holders of senior unsecured debt in failed banks. Their
concern was to prevent damaging contagion in the rest of Europe. A similar argument
was more straightforward and sensible for Cyprus than it had been for Ireland,
and should have led them to oppose Mr Anastasiades’ proposal from the outset.
Second, the festival of finger-pointing
in Brussels and across Europe following the Cyprus debacle shows that the
negotiators had no “plan B” were the Cypriot Parliament to reject their
initial scheme. One must wonder whether the EU is ready to handle the complex Russian
side of the Cypriot equation, including the wisdom of depending on Russian
goodwill for a solution to the current mess.
Third, the Saturday-morning plan raised profound questions
about the democratic nature of EU decision-making. The problem is not that hard
measures were to be imposed on the Cypriot population. A loss of autonomy,
alas, is the inevitable consequence of the Cypriot state’s inability to meet
all its commitments on its own, as Mr. Anastasiades had earlier acknowledged. Moreover, Cyprus has earned no sympathy by
rejecting the United Nations plan for the island’s reunification ahead of its
entry into the EU in 2004, and for harboring Russian and Russian-linked financial
activities widely presumed to be connected with money-laundering.
The problem, rather, lies in the extent to which the
European crisis management is now being held hostage by German electoral politics.
This dynamic is not new in the euro-crisis, but has reached new heights as
Chancellor Angela Merkel’s main opposition, the Social Democratic Party (SPD),
has identified Cyprus earlier this year as a “wedge issue” on which it could challenge
her. The SPD calculation was to paint Ms. Merkel as too lenient with shady
Russian oligarchs and their “black money” held in Cypriot banks, while she
would presumably be prevented from responding because of a fear of destabilizing
Europe’s financial system. In effect, Ms. Merkel called the SPD’s bluff by
risking the euro zone’s first bank run. No wonder that placards on Nicosia’s
streets carry slogans such as “Europe
is for its people and not for Germany,” or that Athanasios Orphanides,
until recently the governor of the Cypriot central bank and a member of the
European Central Bank (ECB)’s Governing Council, complains
that “some European governments are essentially taking actions that are telling
citizens of other member states that they are not equal under the law.”
It is too early to evaluate the lasting damage, but it is
likely to be significant. The Saturday-morning decision-making process leaves
an impression of incompetence and groupthink,
tainting all of the participating actors, including all euro zone finance
ministers, the European Commission, the ECB, and the IMF. The EU’s earlier sense
of purpose by committing to a banking union last June and delivering
on its first step (the Single Supervisory Mechanism) in December has now been battered.
So has the aura of statesmanship and control developed by Ms. Merkel and the
ECB. Possibly most damaging, even if the deposit tax is reversed or adjusted,
the trust of middle-class households throughout the Eurozone in the safety of
their banking system has eroded. Hopefully there will be no immediate deposit
flight in other countries than Cyprus. But in future crisis episodes,
households will behave in a destabilizing way, assuming Europe’s deposit
insurance arrangements are not profoundly reformed. There is an apt parallel
with the Deauville declaration by Ms. Merkel and French President Nicolas
Sarkozy, endorsing losses for Greek sovereign bondholders in October 2010, which
started an 18-months cycle of increasingly negative market expectations
throughout Europe.
What now? A week ago, the challenge in Cyprus was to close
the fiscal gap with a bailout package. Now it is to close the fiscal gap, and
to restore a minimal level of trust in the banking system, without which the
economy cannot operate. This raises the bar. The obvious risk is of massive
deposit withdrawals whenever the Cypriot banks reopen. Now that the seal on
deposit safety has been broken, depositors will do their best to avoid additional
taxation or expropriation in a few weeks’ or months’ time, no matter how many
promises are made that this is a unique and once-and-for-all occurrence.
Cypriot authorities are likely to address this with a mix of capital controls and
deposit freeze, perhaps in the form of conversion of deposits to
interest-bearing certificates of deposits, as recently proposed
by Lee Buchheit and Mitu Gulati. But “financial repression” or even incarceration
can only last for a limited period of time given the freedoms guaranteed by the
EU treaty.
Unlike in previous euro-crisis episodes, there is little the
ECB can do alone. The problem is fiscal at the core and must be addressed by
elected leaders. They may conclude that it is best to let Cyprus default,
impose capital controls and leave the euro zone, an option
that was reported to be explicitly considered in European policy circles. But
such a move would violate the promise of European leaders to ensure the
integrity of the euro zone, no matter what, and potentially set off a chain
reaction, including possible bank runs in other euro zone member states,
starting with the most fragile ones, such as Slovenia and of course Greece.
On the other hand, it is difficult to see how the risky scenario
of a Cyprus exit could be avoided without further fiscal commitments by euro zone
partners, including Germany. Their help could be in the form of additional direct
transfers to Cyprus to plug the fiscal gap, or some form of guarantee of
deposits that would come from the European rather than the national level. A
quick but imperfect way to achieve the latter would be for a European entity,
possibly the European Stability Mechanism, to provide an unconditional
guarantee for a limited but sufficient period of time (say, 18 months) to all
national deposit guarantee schemes in the euro zone, up to the € 100,000
European limit. Such “deposit
reinsurance” has been rejected absolutely by European policymakers so far.
It would constitute a major contingent financial commitment, even though the trust-enhancing
effect would arguably result in an eventual net fiscal benefit for all. But it would
be a powerful preemptive tool to make sure a scenario of retail bank run
contagion does not materialize, and might also become the only option available
to restore confidence if such a scenario were to become reality.
Assuming that the current situation is somehow brought under
control, longer term questions beckon, beyond the geopolitical considerations
related to Cyprus and its neighborhood. The breach of the deposit guarantee,
materialization of the bank run threat, and probable consideration of capital
controls will cast the euro zone debate on banking union in a new and starker
light. Since mid-2012 and until now, the policy consensus in Europe had been to
pretend that the question of supranational deposit insurance, with its direct
links to the currently-frozen issue of fiscal union, was important but not
urgent, and should be left out of the explicit banking union agenda.
This convenient stance will be harder to hold given the Cypriot experience. More
broadly, the episode will contribute to an overdue debate about the democratic
(or otherwise) nature of European decision-making and the effectiveness of its
crisis management, two challenges more tightly connected
than many observers realized. A first step might be to recognize the plan of
March 16 as a mistake, and to have an honest debate about how it could have
been avoided.
Many commentators are puzzled by the general lack of
negative financial market reaction to the fast-unfolding events in Cyprus. The
most likely reason, to be tested in the next few days, is that investors have
been sufficiently impressed by last year’s whatever-it-takes commitments,
particularly those by Ms. Merkel and ECB President Mario Draghi. The markets’ baseline
assumption remains that a last-minute solution will be found after all the
brinkmanship. Longstanding observers of the Eastern Mediterranean tend to
project a darker mood, as they recall that this is a region in which
individuals, groups and nations do not always act in their self-interest.
One can only hope that the market’s assessment is the correct one.