The late Mike Mussa, a former Chief Economist of the International Monetary Fund, 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 announcement on Saturday morning, March 16, of an agreement backed by most European leaders and institutions as well as the International Monetary Fund (IMF), which would impose a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank deposits no matter how small, was a remarkable policy blunder that will carry consequences for the EU.
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 and raised question about the Cypriot government’s own solvency. Negotiations on a possible bailout by the European Union were seen as inevitable as early as mid-2012, but were frozen until a general election in Cyprus last month. Unfortunately, this shifted the timetable of negotiation into German election cycle territory, and thus the position of the Eurogroup, in which Germany is now the unquestioned central actor, has been even more severely constrained by the domestic German political debate than in past euro-crisis episodes. This interaction, on which more below, has led many negotiators to the conclusion that forcing losses on large (read Russia-linked) Cypriot deposits should be an indispensable component of the package.
To the surprise of many, recently-elected Cypriot president Nicos Anastasiades added a further twist to the tangled situation by suggesting a hit to small deposit as well, as a desperate way to limit the losses imposed on large depositors and thus, it is claimed, 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 displayed a remarkable disregard for 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, the fact that a breach of deposit insurance will primarily hurt the “little guys” is virtually undisputed in America. For example, it has been forcefully expressed with reference to Cyprus by Sheila Bair, the well-respected former Chairman of the US Federal Deposit Insurance Corporation. Similar lessons arise from even a rapid review of many recent emerging-market crises.
The fact that the hit on small depositors was allegedly suggested by Mr Anastasiades does not justify its acceptance by the European negotiators. After all, in November 2010 the Troika refused proposals by the Irish authorities to “burn” the holders of senior unsecured debt in failed banks, in order to prevent damaging contagion in the rest of Europe (or so the thinking was). The rationale for the Troika to refuse hitting small depositors in Cyprus was more straightforward than the one for protecting senior bank bondholders in the Irish case. The Troika could and should have acted accordingly.
Second, it is plain from the current pervasive finger-pointing in Brussels and across the EU that the negotiators had no “plan B” in case the plan would not be swiftly endorsed by the Cypriot Parliament. In particular, it remains to be seen how the complex Russian side of the Cypriot equation will be handled, and whether the EU is ready, as it should be for wider geopolitical reasons, to avoid being dependent on Russian goodwill for the handling of the Cyprus situation.
Third, the Saturday-morning plan raised awkward questions about the democratic nature of EU decision-making. The problem is not really that hard measures are imposed on the Cypriot population. This, alas, is the inevitable consequence of the Cypriot state’s inability to meet all its commitments on its own, which was acknowledged in no ambiguous terms by Mr Anastasiades in his statement to the nation on March 16. Moreover, Cyprus has earned no sympathy by rejecting the UN plan for the island’s reunification ahead of its entry into the EU in 2004, and for harboring financial activities by Russian and Russian-linked entities that many Europeans suspect to be partly associated with money-laundering. The problem, rather, lies in the extent to which the European crisis management is held hostage by German electoral politics. This dynamic is not new in the euro-crisis, but has reached new heights as Chancellor Merkel’s main opposition, the SPD, has identified the Cypriot issue earlier this year as a “wedge issue” on which it could destabilize 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 be prevented from responding because this would be too destabilizing for Europe’s financial system. In effect, Ms Merkel called the SPD’s bluff by risking the Eurozone’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, in which all participating actors including all Eurozone finance ministers, the European Commission, ECB, and IMF are tainted. The sense of purpose that the EU had displayed, particularly by committing to a banking union in June 2012 and delivering on its first step (the Single Supervisory Mechanism) in December, has been eroded. So has been the aura of statesmanship and control that Ms Merkel and the ECB, in particular, had gained in 2012. Possibly most damaging, the Saturday announced of the tax on small deposits, even if it is reversed in the next iterations, will probably have dented middle-class households’ trust in deposit safety throughout the Eurozone : hopefully this will not lead to immediate deposit flight outside of Cyprus, but, unless a credible European-level deposit insurance is established, it is likely to affect households’ behavior in future crisis episodes in a destabilizing way. There is an apt parallel with the expectations-shifting impact of the Deauville declaration by Ms Merkel and French President Nicolas Sarkozy in October 2010.
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 falling victims of additional taxation or any other form of part-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 occurence. Cypriot authorities are likely to address this with a mix of capital controls and deposit freeze, perhaps in the form of conversion to interest-bearing certificates of deposits in the form recently proposed by Lee Buchheit and Mitu Gulati. However, “financial repression” or even incarceration can only last for a limited period of time given the freedoms enshrined in 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 Eurozone, an option that is being reported as explicitly considered in European policy circles. This would unambiguously violate the oft-made promise of European leaders to ensure the integrity of the Eurozone no matter what. The most immediately relevant question in that case is about the chain reaction, including possible bank runs, that this violation might trigger in other Eurozone member states, starting with now-fragile ones such as Slovenia and, of course, Greece, and possibly extending to other economies closer to the Eurozone “core.”
It is difficult to see how the risky scenario of Cyprus exit could be avoided without further fiscal commitments by Eurozone partners including Germany, either of additional direct transfers to Cyprus to plug the fiscal gap, or of some form of guarantee of deposits that would come from the European rather than the national level. A quick but very 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 Eurozone, up to the € 100,000 European limit. Such “deposit reinsurance” has been considered an absolute no-go 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 if such a scenario were to become reality.
Assuming that the current situation is somehow brought under control, longer-term questions beckon, even leaving aside relevant geopolitical considerations regarding 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 Eurozone 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 feed an overdue debate about the democratic (or otherwise) nature of European decision-making and the effectiveness of its crisis management, two challenges that are more tightly connected than many observers seem to have realized. A first step might be to acknowledge the Saturday-morning plan of March 16 for what it was, a policy mistake, and to have an honest debate about how it could have been avoided.
Many commentators have declared themselves puzzled over the past few days by the general lack of negative financial market reaction to the fast-unfolding events in Cyprus. The most likely reason, which may 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, so that their baseline scenario 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 best self-interest. One can only hope that the market’s assessment is the correct one.