Sunday, March 17, 2013

Echoes of 1933: the Cyprus Heist

Bank depositors in Cyprus learned today of a planned heist on their funds. It was a well organized one that will take 6.75% of all small deposit accounts and 9.90% of all large depositor accounts. What is truly shocking about this heist is that it was planned by the EU and IMF and applied to funds, at least for the small depositors, that were supposedly government insured (i.e. risk free). This is what we call a major shock to expectations.

Now the depositors do get bank equity in exchange and some observers note this heist is not as bad it could be--the alternative could have been a complete financial collapse--but from a broader perspective these excuses miss the mark. The very reason the crisis has got to the point that bailouts or "bail-ins" are needed is because the Eurozone was a flawed monetary union from the start. It never met the criteria of an optimum currency area and its monetary policy has effectively been geared toward Germany. Thus, at the advent of the Euro, the ECB policy interest rate was close to what a Taylor rule would predict for Germany, but far too low for the periphery. Likewise, since the crisis the policy rate has been close to what a Taylor rule would predict for Germany, but too high for the periphery. In both cases, ECB policy has been destabilizing to the periphery. That is why, despite being in the midst of a crisis, the ECB explicitly tightened monetary policy in 2011 by twice raising its policy rate. It is also why the ECB has implicitly (or passively) tightened policy over the past few years as evidenced by the flatlining of the broad money supply and nominal GDP. In short, the boom-bust cycle of the Eurozone periphery that helped make the Cyprus financial crisis is largely the result of a flawed monetary system biased toward Germany.

But that part is not new. What is new is the unexpected seizing of depositors funds. As Lars Seier Christensen, Ed Conway, Felix Salmon, and Frances Coppola note, this sets a dangerous precedent for all Eurozone bank deposits.  Here is Coppola:
[T]he fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too.
Yes, EU leadership promised this action was a one-off event, but the fact that they had to make this promise is a sign that they no longer can be trusted. Just imagine what you would be thinking now if you were a resident of troubled periphery economy and had funds in your bank account. I suspect it would be whether my bank was next and whether I needed to get my funds out ASAP. It is almost as if the EU and IMF were trying to create a banking panic in Europe.

What the EU and IMF did to Cyprus today is poised to be a repeat of what happened to U.S. banking in 1933. In February of that year, the governor of Michigan declared a statewide banking holiday as a means to resolve an impasse on how to wind down an important bank in Detroit. Like the Cyprus action today, the governor's actions back then sent chill waves across a continent, as depositors in other states began to wonder if their governors would also call bank holidays to prevent withdrawal of funds. The fear was so poignant, that the Ohio governor made it a point to declare the bank holiday would not happen in Ohio. But it was too late, the die had been cast. By March 1933, 48 states had declared some form of bank withdrawal restrictions as the bank panic spread and fed upon itself. Only with FDR's national bank holiday and the advent of national deposit insurance in March, 1933 was the bank panic stopped.

What is crazy about the Cyprus heist today is that it has the potential to create the same self-fulfilling bank panics across Europe, but without the benefits of a unified treasury to credibly commit to Eurozone deposit insurance. I can't help but hear the echoes of 1933 now unfolding in Europe. 

Update I: Our friend Lars Christiensen, the Market Monetarist one, also weighs in with good thoughts.
Update II:  A fitting picture on the Cyprus heist:


  1. You should point out that the levy on Cypriot deposit starts at accounts of 100,000 euro. It is targetting Russian and British tax evaders. Also, after the two ECB rate rises, they took it down once, the ECB is less active than say, the Australian Central Bank, or Canada or Sweden and no different than the Bank of England.

    The current problems in the periphery are caused by excessive government borrowing and rising bond markets rates. The ECB has not been party to that transaction untill September 2012 when Mario Draghi committed to buying periphery bonds. It's no surprise really that commitment reduced rates and calmed things down.

    The Eurozone is using internal capital flow to benefit periphery countries, northern states back periphery debt, periphery rates come down. This would never happen without a working Eurozone. Prior to the Euro Portugal had borrowing rates around 12%, Spain the same, Greece 19%, how they have 6%, 5% and 10%. Naturally, it took a "crisis" to test and implement this process, it would have been impossible and unnecessary to get these commitments from the northern states if the south was in a boom.

    As much as the tabloid media and certain politicians like to cry "Eurozone crisis" at every opportunity, it is petering out in reality. In the history of the Euro there has been one major crisis - caused by American banking collapse. The crisis has been dealt with, the bond markets rates are the proof. The next problem is creating growth and jobs, and the EU Leaders and IMF have been talking about that since at least Q3 of 2012. Once the national leaders get on board with that discussion, it'll get done and the so-called Eurozone Crisis will be history. Or we'll just bumble on through the well documented boom-bust-recession-recovery cycle and then the so-called Eurozone Crisis will be history.

    I think it's safe to say the global banking landscape today is so far removed from 1933, those comparisons are of questionable practical value.

    1. SoupWaiter

      This is factually incorrect. There is no floor on the Cypriot deposit levy. It applies to all deposit and current accounts however small the balance. Balances below E100,000 are subject to a 6.75% levy: above that the levy is 9.99%. It is currently unclear whether the 9.99% applies to the whole balance or just to the residual amount above E100,000k.

    2. Frances is correct, but incomplete. In addition to the little guy getting whacked with a deposit haircut (despite "deposit insurance"), it must be noted that the ECB & hedge funds will not have a haircut imposed on their lending to the banks.
      This will reawaken contagion risk elsewhere in the euro zone.
      Does anyone recall Creditanstalt?

    3. The real travesty of the financial crisis is the distributional consequences. Finance executives not prosecuted because their firms are "systematically important" but little guys get reamed.

    4. CORREX: their firms are "systemically important"

  2. " It never met the criteria of an optimum currency area and its monetary policy has effectively been geared toward Germany. Thus, at the advent of the Euro, the ECB policy interest rate was close to what a Taylor rule would predict for Germany, but far too low for the periphery. "---Beckworth.

    This is an amazing observation. Worse still--how does a regular guy in Europe vote for a more-aggressive or expansionist monetary policy?

    Does the idea of a "independent central bank" stand scrutiny?

    This is pathetic---voters in Europe can storm at their elected officials, who trot outdone harebrained scheme after another to make things better---when it is the ECB that could make things better.

    More and more, I am coming to believe a central bank should be sovereign, and have a chairman appointed by an elected president or prime minister, to serve co-terminously.

    Can anyone point at Europe and defend independent central banks (the ECB(, either on economic terms or democratic terms?

  3. Apparently the cypriot parliament can amend the bailout, but the financial contribution of 5.8 bn euros remains.

  4. First Deposit insurance is a system established to protect depositors against the loss of their insured first deposits placed with scheme members in the event the depositors making loss in trades.
    Deposit Insurance Coverage