I come from a nautical family. One expression I learnt as a child was: “Don’t sink the ship for a ha’penny worth of tar”.
The weekend agreement on a rescue of the Cypriot banking system flagrantly disregards this sound advice. The ship in question is not the banking system of that Mediterranean island, which is to be ‘saved’ with the provision of about EUR 10 billion in EU and IMF funding. It is the entire euro area economy. Accordingly the missing tar – a thick resin used to seal the hull of wooden ships in olden times – in this case costs a bit more than half a penny: EUR 5.8 billion to be precise. That is the sum that holders of Cypriot bank accounts will be forced to stump up in the form of a one-off levy: 6.75% on all deposits up to EUR 100,000 and 9.9% above that.
That may sound a lot. Well, it is a touch over ten euros for every EU citizen. More relevantly, it represents less than 0.05% (one two-thousandth) of euro area annual GDP. And it is a safe bet indeed that the knock-on damage on economic output of this deal will be far higher, with a substantial tail-risk of a renewed lurch into crisis. Why is that?
All advanced capitalist economies provide state-run deposit insurance, up to a certain limit. It is the single most important element in preventing devastating bank-runs. (Banks only ever hold a relatively small proportion of the money deposited with them. The rest is lent out. If doubts arise about the safety of those deposits, customers will seek to withdraw them. Once they start to do so the risk becomes a self-fulfilling prophecy.)
In the wake of the 2007/2008 financial crisis all European Union countries committed to a common ceiling of EUR 100,000. Account-holders with less were never to suffer losses. This is key to underpinning confidence in the banking system and thus the normal flow of credit in the economy. (If you are wondering why the the deposit insurance will not be paying out in this case, the answer is that such insurance covers actual financial losses by the bank. The levy is a form of tax on account holders that any government with a majority in Parliament can impose on its population. This explanation will satisfy lawyers, but there is no real economic difference given that the levy is being used to stem bank losses, and there is no reason to expect that such a distinction will placate irate account holders.)
For the sake of a paltry EUR 5.8 billion, then, this crucial principle of sound economic management has been effectively scrapped. At the very most a levy on accounts above EUR 100,000 should have been imposed. (Although given the orders of magnitude involved, even this I would consider an unnecessary risk to take.) Depositors, particularly in countries with shaky banking systems such as Spain and Italy, but very likely in other countries as well, are certainly asking themselves this morning whether their money is safe. If they start making substantial withdrawals, a shadow will be cast once again over the whole European banking system and thus over the prospects of emerging from the crisis. Of course, policymakers have assured voters that Cyprus is a special case requiring special measures. But we have heard this before, when holders of Greek sovereign bonds suffered a haircut – of which more in a minute.
In recent weeks the Cypriot banking sector has been subjected to a barrage of criticism which will go a long way to placating all those Europeans who do not hold accounts there, and are tired and suspicious of taxpayers having to stump up for the failings – so the perception – of undeserving others. Indeed, reporting seemed to have an element of a concerted campaign to soften up public opinion. At the very least it pandered, in an uninformed way, to popular restments and clouded the issues at hand. For many of the arguments made are very largely either specious or irrelevant or both.
The island’s banking system is supposedly awash with Russian money that the Cypriot banks have been happily washing for a handsome profit. It seems that in fact only around 15 out of EUR 68 billion is held by non-residents, mostly Russians and Britons. So domestic account-holders will take by far the biggest hit. In any case: so what? Cyprus is a Mediterranean island. It is not the Ruhr area or the Emilia Romana. It is no surprise that it seeks to pay its way in the world with tourism and financial services. It has a large number of ex-patriat residents, not coincidentally including many Russians and Brits with whom there are cultural and linguistic/historical ties.
It may well be that some of the money brought in by wealthy Russians has a nasty smell about it. But the origin of such money is primarily an issue for Russian lawmakers. If it was legally brought into an EU country then it offers no ground for retribution. It certainly cannot be laundered simply by paying it into a Cypriot (or any other) bank account and taking it out again. To the extent that any fraudulent activities have taken place, this is a matter for the financial authorities and individuals guilty of wrongdoing should receive appropriate punishment: this is no justification for an across-the-board levy, particularly one that hits the very smallest savers.
More fundamentally, I have seen not a scrap of evidence that the inflow of Russian capital has been the Achilles’ Heel of the island’s banks. In fact it is very obvious what critically weakened the Cypriot banking system: the haircut on Greek bonds which was decided by, yes, the same European governments and EU and international institutions that are now imposing a haircut, this time called a levy, that is once again sending shockwaves through the financial system. The Greek haircut was a bad idea for slightly different reasons (for the prediction see here, for the impacts here), but it was inevitable that the value losses (around half) on such bonds would cause massive problems for banks holding large amounts of Greek public debt. It is quite understandable and normal that the banks in (Greek-speaking) Cyprus have relatively large holdings of Greek government bonds. This is not speculation: holding the bonds of your own government – or if you are a small island those of a government with which you have close relations – is a hum-drum, essentially risk-free affair: or rather, it is supposed to be.
Greek bond-holders last time (unique!), Cypriot deposit-holders this time (also unique!). Who’s next? That is the question reverberating around Europe this morning. Even if a major renewed crisis is avoided, this agreement will cost growth and jobs, and not just in Cyprus. Once again the weaknesses of a primarily intergovernmental approach to running the monetary union have been exposed. (From what I have garnered from the media about the negotiations, this is one case where the EU Commission is entirely blameless.) The urgent need is to press ahead with banking union and to back up the fine words on “doing what it takes to save the euro area” (Draghi) with equally firm action. Instead, onec again policymakers will be manning the pumps.
The ship, in other words, needs new steering gear and a new set of sails. The risk is that the ship might sink while those are being put into place – for a ha’penny worth of tar.