From the island of Cyprus came Pygmalion and Aphrodite, symbols of love and beauty. That was long ago. Now we have an agreement by its President to concede to a request from Brussels that might have equally far-reaching consequences, but of a less pleasing nature.
Last Friday, the 17 Eurozone finance ministers and the IMF demanded that a percentage of all Cypriot bank deposits be confiscated, in return for a desperately needed loan of €10 billion to the country. According to the Financial Times, this €5.8 billion “tax” was demanded by a German-led group of creditor countries. The decision was seen as a means of transferring risk and responsibility from outside creditor nations to creditors in the countries that had incurred the debt.
Recently elected President Nikos Anastasiades agreed to the deal and asked that Parliament acquiesce to its terms. That was despite the fact that expropriating 6.75% of all deposits up to €100,000 (government insured deposits) violate what has always been an inviolable principal – that insured deposits are sacrosanct. Many of those deposits represent the life savings of Cypriots. On the other hand, approximately €35 billion of the €65 billion in deposits is in uninsured accounts – amounts above €100,000. Of those accounts, a payment of 9.9% has been demanded. Making things interesting is that more than half of all uninsured deposits belong to Russian oligarchs, or, at least that is the word from the Financial Times, which on Monday suggested that this move might cost Russian depositors €2 billion. One of the concerned Russians is Vladimir Putin who allegedly is a depositor. Mr. Putin, according to the FT, thought, unsurprisingly, that such a step would be “unfair, unprofessional and dangerous.” (It’s interesting that he used the word dangerous!)
An editorial in Tuesday’s New York Times criticized the deal, but referred to the confiscation of assets as a tax, which it isn’t. They argue that the amount taken from insured accounts should be less and that taken from larger accounts should be more – that “imposing a bigger tax on deposits of more than €100,000 would not have the same ripple effect on confidence.” That may be so, but banking is one of Cyprus’ most important industries. Effectively shutting it down will not do much for the average Cypriot.
The country is considered by many as a unique situation. Cyprus is a bank haven. The country has €65 billion in bank deposits, an abnormally large number for a country with a population of 1.1 million and a GDP of about €20 billion, slightly smaller than Vermont. Their banks, moreover, have been accused of money laundering. Second, its bank’s liabilities are almost entirely composed of deposits. In any reorganization, bonds typically come before deposits. But in the case of Cypriot banks, their asset base is almost entirely off-set by deposits. Depositors are being offered equity in compensation for the confiscation, but Brussels’ demands may seal shut a number of Cyprus’ banks, rendering any equity worthless. Money will assuredly leave the island, effectively shutting down a major employer.As a factor in the Eurozone’s GDP, Cyprus, at 0.2%, is meaningless; yet this decision is significant, as it risks creating a Tsunami of withdrawals across the region. If insured deposits are not sacrosanct, what is? Economies are built on credit and credit demands trust. Europe has enough problems. Eurozone GDP declined 0.6% in the 4th quarter of 2012. Employment has been steadily declining from the 2nd quarter of 2011. Unemployment in the area varies greatly, from 5% in Germany and Austria, to 27% in Greece and 26% in Spain.
The decision has been made not to open the banks until Thursday, giving lawmakers more time to consider how they might vote. (Incidentally, late yesterday the German finance minister warned that it is unclear if their banks will ever be able to reopen.) Regardless of the vote in Parliament, though, the die has been cast in terms of government accessing bank deposits. Monday’s New York Times quoted Stelio Platis, a banker and economic advisor to Mr. Anastasiades: “Whether Parliament approves the measure or not, the effect will be the same. As soon as banks in Cyprus reopen, people will rush to take their money out.” As well, it will be hard for depositors to have faith in banks located in other financially weaker Eurozone countries – a list that would include Greece, Italy, Spain, Portugal, Ireland and possibly France. While Switzerland is the most obvious beneficiary of the foolishness of Eurocrats, the U.S. might be as well – not because of the fiduciary responsibility exhibited by our bankers and politicians, but because the Dollar serves as the world’s reserve currency. But that could prove short-lived, as we are treading the same path trail-blazed by our European friends, in our quest for a political and financial system that is “fair” to all, in all ways.
The adoption of the Euro in 1999 merely postponed the death of a decaying welfare system for many European countries, a system which was birthed in the aftermath of World War II. Initially, before costs soared faster than revenues, it looked like Europe’s leaders had found Nirvana – a system that allowed for fewer work hours, long vacations and early retirement. It seemingly permitted all to share in the fruits of the continent’s economic success. But that began to change as expenses rose faster than revenues. Promises were made regarding health and retirement plans, but they used actuarial assumptions that had little to do with reality. Higher taxes sapped initiative. Gradually, the costs of their promises dawned. This was especially true for those countries along the Mediterranean. However, the adoption of the Euro extended this dream. Had these countries stayed with their own currencies, the discipline of the market would have forced more rational behavior. Interest costs would have risen and currencies would have declined. Access to credit would have been more difficult. And any collapse would have been more localized.
However, under protection of the Euro, countries like Greece, Italy, Cyprus, Portugal, Spain and Ireland were able to persist in their profligate and speculative ways. Germany, the beneficiary of a Euro that was priced lower than the Deutschmark, saw her exports increase. As Europe’s strongest and best managed economy, Germany played a major role in financing her more promiscuous neighbors. Now, German voters are becoming disgruntled…and Angela Merkel faces an election this year. Wanting to be seen as tough on debtors is part of her strategy. Adding to the problem, Eurocrats do not want to admit that what they wrought may not be working. Mario Draghi, president of the European Central Bank (ECB) and sounding increasingly like Cassabianca standing alone on the burning deck, vows to make good on his promise “to do whatever it takes” to protect the Euro. His words, it seem to me, resonate with those of George Orwell, when in 1946 he argued against England’s desire to continue its rule in India as a “defense of the indefensible.”
I remain of the opinion that ultimately the Euro will fail. The 17 countries that comprise the Eurozone have a population of about 330 million, with a GDP of approximately €9.5 trillion. It is a relatively small geographic area, but the differences among the myriad people are large – in language, customs, legal systems, culture and behavior. The ideal of a single unified economy, functioning with a single currency was a wish devoutly to be consummated. But, while such a union offers many advantages, it also serves as an impediment in allowing countries to extricate themselves from financial difficulties, the principal one being that a country that gets in trouble cannot devalue its way out. Austerity, whether it is imposed on government through curtailing spending, or on individuals by raising taxes will not work. If you were Greek, would you want to take instructions from Germans? Economies need more flexibility. Government should serve as a guide and governor, but not the engine. Economic growth is dependent on the invisible hand of Adam Smith and the creative destruction of Joseph Schumpeter. It is hard for that to happen, if one lives in Cyprus and every month sends a check to Germany.
Equitable outcomes are antithetical to capitalism, which is a system that relies on the rule of law and the sanctity of property law. It is a system that rewards those who excel and punishes those who fail. Its hard edges have been smoothed down by democracy. Thus it assures equality of opportunity and helps protect the poor, the sick and the elderly. As a consequence, democratic capitalism has done more to improve human welfare than any other system devised, essentially because it is dependent on democracy which assures equal opportunity and fairness under law. By its nature, it allows individuals, companies and societies to advance in an evolutionary manner. In so doing, they prevent the far bigger failures that inevitably result from government interference. But it is fragile; and the biggest risk the system faces is the one from within – destroying the system in the interest of fairness and trying to ensure equalities of outcome. Like many (or most) European nations, Cyprus lived beyond its means for too many years. Consumption exceeded savings. The current welfare system has denigrated personal responsibility and elevated dependency. It is a system that focuses on comfort today, but ignores the demands and needs of security tomorrow.
There are many who look at Cyprus as a one-off – because of the capitalization of banks and the fact that the island is a bank haven. But the problem is that what Brussels is trying to do in Cyprus is symptomatic of a bigger problem, of politician acting with no respect for the rule of law and without regard to consequences. If the German finance minister is correct, his fellow ministers in Brussels may have opened Pandora’s Box. The concept that a state might not be able to protect insured deposits is inimical to the nature of democratic capitalism. No matter how Parliament votes, that genie is out of the bottle. Arguing that Cyprus is a special case is like a libertine telling his creditor that the check is in the mail.
“Thought of the day” by Sydney Williams
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