The late Mike Mussa1 noted 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 ten days around Cyprus.
The 16 March 2013 ‘Troika’ agreement on Cyprus’s rescue was a policy blunder that will cost the EU dearly. The deal – backed by most European leaders and institutions at the time, as well as by the IMF – called for a tax on all holders of bank deposits in Cyprus, no matter how small (in the form of a possibly unfavourable cash-for-equity swap).
The sequence that led to this 'Saturday-morning plan' is well known. Negotiations on a possible bailout by the EU had been seen as inevitable as early as mid-2012.
- Greece’s debt restructuring hit Cypriot banks hard, raising doubts about the Cypriot government’s own solvency.
- Discussions were frozen until the Cypriot general election last month.
- This delay brought the negotiations within sight of the German election cycle, thus constraining Eurogroup’s latitude (Germany is the group’s central actor).
Driven by German domestic politics, forcing losses on large (read: Russian-linked) Cypriot deposits became an indispensable component of the package for European negotiators.
- To the surprise of many, Cypriot president Nicos Anastasiades, suggested adding 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 centre. All negotiators seem to have accepted this offer before realising, too late, how damaging it might be to trust in the safety of bank deposits well beyond Cyprus.
While there is no ‘silver bullet’ solution, some of the Saturday morning plan’s flaws were avoidable, as the much more sensible revised plan adopted on 24 March illustrates.
The avoidable deposit insurance mistake
First, the plan disregarded the lessons of financial history about the high importance of deposit safety. This is particularly important for middle-class households (which is why there usually is an upper limit for explicit deposit insurance, harmonised 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 (Hobson, 2013). Similar lessons arise from the record of many recent emerging-market crises.
- Even if, as alleged, it was Cyprus’s own president who recommended hurting small depositors, European negotiators were not justified in going along.
- After all, in November 2010 the Troika did a similar thing with Ireland.
The EU, ECB and the IMF rebuffed Irish authorities’ proposal to 'burn' the holders of senior unsecured debt in failed banks. The refusal was aimed at preventing 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.
The lack of a plan B mistake and lack of democratic accountability
Second, the festival of finger-pointing in Brussels and across Europe during most of last week demonstrated that the negotiators had not thought of any 'plan B'. They didn’t think ahead on the possibility that the Cypriot parliament would reject this Saturday morning plan, as it did spectacularly with no single vote in favour at the beginning of the week.
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 was, alas, inevitable given Cyprus’ inability to meet its commitments; Mr Anastasiades acknowledged as much in his public statement on the 16 March package. 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 harbouring Russian and Russian-linked financial activities widely presumed to be connected with money laundering.
- The problem lies in the extent to which the European crisis management appears to be increasingly held hostage by German electoral politics.
This dynamic is not new. It has, however, reached new heights as Chancellor Angela Merkel’s main opposition, the Social Democratic Party (SPD), identified Cyprus earlier this year as a 'wedge issue' on which it could challenge her.
- The SPD calculation was to paint Chancellor Merkel as too lenient with shady Russian oligarchs and their 'black money' in Cypriot banks; they assumed she could not respond for fear of destabilising Europe.
In effect, Merkel called their bluff by risking the Eurozone’s first bank run.
No wonder 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 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” (Weisenthal, 2013).
The damage is significant.
- The Saturday morning decision-making process on 16 March left an impression of incompetence and groupthink.
This taints all of the actors: the Eurozone finance ministers, the EC, the ECB, and the IMF.
- The Eurozone’s sense of purpose has suffered.
The reputational gains from last year’s commitment to banking union and delivery on the first step (Single Supervisory Mechanism) have been battered. So has the aura of statesmanship and control developed by Merkel and the ECB.
- Possibly the most damaging aspect is the erosion of trust of middle-class Eurozone households in the safety of their banking system.
Even though the deposit tax was partly reversed in the latest iteration, households will remember that it was proposed. In future crisis episodes, households are likely to behave in a more destabilising way, unless Europe’s deposit insurance arrangements are profoundly reformed.
There is an apt parallel with the Deauville declaration by Merkel and former French president Nicolas Sarkozy endorsing losses for Greek sovereign-bond holders in October 2010. This started an 18-month cycle of increasingly negative market expectations throughout Europe (Neuger 2013 and Ubide 2013).
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 had no choice but to address this with a mix of capital controls and deposit freezes.
But 'financial repression' can only last for a limited period of time given the freedoms guaranteed by the EU Treaties. The plan of 24 March is much better than that of 16 March, but it remains to be seen what financial dynamics it is going to trigger.
Assuming that the current situation remains broadly under control, longer-term questions beckon.
First, Cyprus casts the Eurozone banking union in a new and starker light. Since mid-2012, the EZ policy consensus pretended that the question of supranational deposit insurance was important but not urgent, so it should be left out of the explicit banking union agenda (Veron and Wolff 2013).
This pretension has been exploded by:
- the breach of the deposit guarantee,
- the materialisation of the bank run threat, and
- capital controls.
The notion that EZ-wide deposit insurance is an essential element of the euro’s institutional architecture is back to the fore after the Cypriot experience.
Second, the episode will contribute to an overdue debate about:
- the democratic underpinnings of European decision-making; and
- the effectiveness of its crisis management.
These two challenges are more tightly connected than many observers realised (Veron 2012). A first step might be to recognize the 16 March plan as a mistake, and to have an honest debate about how it could have been avoided.
Hobson, J (2013), “Sheila Bair: Cyprus deposit tax unlawful, destabilizing”, Marketplace Morning Report, 19 March.
Neuger, J (2013), “Deauville Zombie Strikes as Cyprus Tax Inflames Crisis” Bloomberg News, 19 March.
Ubide, A (2013), “Reengineering EMU for an Uncertain World”, Peterson Institute Policy Brief 13-4, February.
Véron, N (2012), “The Political Redefinition of Europe”, speech at the Swedish Financial Markets Committee (FMK) Conference, Stockholm, 8 June.
Véron, N and G Wolff (2013), “From Supervision to Resolution: Next Steps on the Road to European Banking Union” Policy Brief 13-5, February.
Weisenthal, J (2013), “Former Cyprus Central Banker Goes Off On The EU And Says The European Project Is Dying” Business Insider, 19 March.
1 Mussa who worked at the Peterson Institute for many years was a former Chief Economist of the International Monetary Fund (IMF). His quip was about some episodes of the late-1990s Asian financial turmoil.