Remember when the pair of lions sneak up on a herd of wildebeest? The lions pounce on the weakest one. The others are startled, watch the lions munching on their brother for a minute or two, and then go right back to grazing. “Better him than me”, they appear to think. And so goes Iceland, Ireland, Spain, Portugal, Italy, Greece and Cyprus. The Dutch and French and Germans just keep grazing that grass.
Ok so what went wrong in Cyprus. Floyd Norris helpfully noted that Cyprus is a bit smaller than the state of Vermont, so let us begin there. Cyprus is a user of the euro; Vermont is a user of the dollar. Neither issues its own sovereign currency. Both have banks that issue deposits denominated in the currency they use—the euro deposits in Cyprus look exactly like euro deposits in any Euroland nation; the dollar deposits in Vermont look just like dollar deposits anywhere in the USA. There are no capital controls among Euronations, nor among USA states. The Eurozone has a central bank—the ECB—and the USAzone has the Fed. These central banks clear accounts for their respective banking systems. So far so good.
There are three fundamental differences, however.
Cyprus is responsible for regulating and rescuing its own banks; Vermont has some supervisory responsibility for its state-chartered banks (I suppose there are some), but the FED, OCC and FDIC oversee that. Further, if the you-know-what hits the fan and Vermont’s banks get in trouble, Uncle Sam (Fed+Treasury) comes to the rescue. If Cypriot banks get in trouble, it is the government of Cyprus that must bail them out. (Good luck with that!) When it cannot, it goes hat-in-hand to the Troika to beg for pennies, offering to sell all the royal jewels to the Germans in return.
Second, while both Vermont and Cyprus are currency users (not issuers), only Vermont has a direct line to Uncle Sam’s national treasury—which spends over 20% of USAzone GDP across Congressional districts to keep the pork flowing. Cyprus has no Uncle Fritz, and in any case the EU Parliament spends well under 1% of Eurozone GDP, mostly to subsidize farmers. In a deep economic downturn, Cyprus is on its own; by contrast, Vermont got a share of President Obama’s Trillion Dollar Deficits.
Third, while Vermont’s electorate has some independence to determine laws that apply to the state, in many areas federal laws trump. Witness the national debate about whether individual states have the right to marry gays or let people partake of particular herbs. Cyprus has much more leeway to decide what goes on within its borders. (I realize that part of the reason to unify has been to harmonize laws—but Eurozone nations are more tolerant, which is precisely why there is so much anger now about what periphery nations have been doing….)
Now why are these differences important? Think back to the days before 2008. Ireland was the Eurozone’s preferred bank haven. It issued euro deposits and paid handsome interest rates. Its banks blew up to gargantuan size. When the crisis came, the banks went bust and the deposits flew out.
Depositors looked for an alternative, and Cyprus was the lucky recipient of hot flows of deposits.
Cyprus marketed itself as a new offshore—but very close and safe—repository for euro deposits. It was European, but with substantial independence to set its own bank operating rules—which were purposely kept loosey-goosey. You see, the 500 Euro note has become the favorite currency for international crime (as Norris points out, the USA only issues the measly $100 bill).
Without casting dispersions, one might note that a lot of the deposit-holders in Cypriot banks happened to be Russians. Coincidence? You decide.
By 2008, Cyprus was gaining $41 billion of deposits per year, over 160 percent of the tiny island’s GDP. Banks and Beaches were the only thing Cyprus had on offer.
Cypriot banks made loans to the Cypriot government. Why not? What could possibly go wrong? Unified currency, access to ECB for clearing, member of the biggest economy in the world.
Then the dominoes start to fall; ratings on government debt fall as tax revenues fall (and, to be sure, some periphery nations were not all that good at collecting taxes in the first place) and interest rate spreads rise—blowing up government budgets.
Cyprus doesn’t look so good any more. Her banks are holding risky government debt, and become insolvent. The Troika demands taxes on deposits to recapitalize the banks. Investors the world-over are shocked, shocked! that deposits in euro banks are not safe.
You know the rest of that story: banks are closed and no one can get deposits. The Troika has to back-off on plans to “tax” (seize) everyone’s deposits, and “compromises” with a haircut of up to 40% on deposits above 100k euros. Capital controls have been imposed for the foreseeable future, restricting the amount of cash allowed to be taken from ATMs, and prohibiting check cashing and electronic transfers.
I think we call that “closing the barn door after the cows got out”. The time for capital controls would have been in 2008—to keep the damned hot money cows out! But the wildebeests in Cyprus just went on grazing while the lions fed on Ireland, then welcomed the lions into Cyprus.
To understand the sheer folly of all this, think again about Vermont.
Suppose Vermont decided to declare itself an offshore banking paradise. Its banks would offer dollar deposit accounts to all drug running, money laundering and terrorist outfits from around the world—encouraging the worst money laundering banks (think HSBC and BofA) to expand their operations in Vermont. No restrictions, perfectly free flowing capital. All tainted dollar-denominated money flows into Vermont from the USA, the Bahamas, and the world beyond.
Lots of new jobs are created in handling the tainted money. The economy grows rapidly. The state government realizes it can afford more pork. Expecting revenues to rise forever, it decides to issue debt against future taxes. Its banks load up on state government debt.
The global financial crisis hits. Hello, Washington, We’ve Got A Problem. Can you spare $20 billion?
And so it goes. The Troika will provide 10 billion in loans, of which 1.4 billion will be used by the government of Cyprus to make a payment in June to hedge funds that have been scooping up government debt for pennies on the euro in expectation that the Troika would eventually blink.
Cypriots lose all their banking jobs. And their life’s savings. They send their kids off to Germany to slave away in permanent peonage.
And the wildebeests in Euroland munch on.
Update: See here: http://www.brettonwoodsproject.org/art-572235
“It is often said that the best way to rob a bank is to buy one. During the last few years, Laiki Bank and Bank of Cyprus lent billions to members of their boards and shareholders without receiving the required collateral and guarantees1. A little-understood but important contributing factor to the Cypriot banking crisis was the investment in and exposure to Greek bonds from the secondary market as Cyprus’s banking business model began to feel the strain of reduced investment flows, due to the European financial crisis unfolding around it. Cyprus’s major banks turned to Greek sovereign debts as a desperate strategy to find cheap but profitable investments, despite the obvious risks from exposure to Greece.
Laiki Bank and Bank of Cyprus, Cyprus’ two major banking institutions, in particular bought ‘toxic‘ Greek bonds in the last few years, often at a discounted value as other European banks sought to divest themselves of the increasingly risky debts of Greece. In one prominent example, Greek sovereign bonds were purchased at an 18 per cent discount to their nominal value through the brokerage of Bank of Cyprus, from Germany’s Deutsche Bank. Deutsche was so desperate to sell that it had even offered 5 per cent commission to any agents who succeeded in selling these ‘toxic’ bonds. This catastrophic investment, whose losses were realized once Greek bonds were forcibly devalued by Greece’s latest Troika deal, represented €100 million euros of revenue for Bank of Cyprus’ brokerage company. Greece’s revised bailout conditions that were agreed by the Troika in December imposed a widely expected ‘haircut’ on holders of Greek bonds, forcing the Cypriot banks to accept major losses. This was the death-knell for Cyprus’s irresponsible financial titans. The likely losses on Greek bonds were widely identified in advance both locally and internationally, yet the Cypriot central bank dismissed them. When the haircut was inevitably applied, both banks collapsed.”
And so the Germans had them coming and going!!!