Tale of Two Euros

The past two weeks of the Cyprus banking crisis have been chaotic at the least, and challenging known economic theory at the worst.  The most recent developments, in my opinion, may be creating the biggest risk the unified currency has faced at any point in this crisis.

The first steps involving “resolving” the banks are exactly as they should be:  Burn up the stockholders, then the bondholders, then the uninsured depositors.  Moral hazard is removed from the equation and risk is compensated in the accepted hierarchy.

The next step, however, is the source of my concern.  That step involves implementing capital controls.

Implementing capital controls is neither a new nor unilaterally negative phenomenon.  Their use has ebbed and flowed throughout history.  They were prevalent during World War I, eased in the years leading up to the rise of the Nazi party, and returned in forms such as the tax imposed by the Nazis on the Jews attempting to leave Germany to avoid oppression.

During John Maynard Keyne’s heyday (the Bretton Woods era), capital controls were widely implemented and were considered a lynchpin in controlling the breakouts of banking crises.  The history of that era would certainly validate that correlation (although not necessarily proving causation).

August 15, 1971 marked the end of Bretton Woods when Nixon abolished the gold standard.  From that point until the most recent financial crisis, capital controls were largely eliminated – first in the developed countries and later in the emerging markets.  Lack of capital controls accelerated globalization while, at the same time, increasing the likelihood of banking crises.

Then came the 2008 financial crisis and the Great Recession.  Suddenly countries pined for the good old days of Bretton Woods – or at least the financial stability capital controls brought to that era.  Keynesian economic policies began being implemented across the West with bond-buying programs and the manufacturing of money being the perceived saviors from the crisis.  Perhaps it was a natural progression, then, that Keyne’s other belief – the usefulness of capital controls – would surface at this time.

Which leads me to my confusion about the controls about to be implemented in Cyprus.

Capital controls don’t exist in a vacuum.  In fact, one model of capital controls involves the idea of the “Impossible Trinity.”  Basically, the Impossible Trinity says that countries desire three fortuitous things:

  • Free capital flows (no capital controls)
  • A fixed exchange rate
  • Sovereignty over monetary policy

The rub, however, is obtaining all three is an impossible trinity.  A country can only have two at the expense of the third.  Graphically, it works like this:


A = Free capital flow and fixed exchange rates; therefore, there will be no sovereignty in monetary policy

B = Free capital flow and sovereignty in monetary policy; therefore, there can be no fixed exchange rate

C = Fixed exchange rate and sovereignty in monetary policy; therefore there will be no free capital flows

Flipping the formula for “C” over, implementing capital controls leaves you with two desirable levers:  Fixing your exchange rate and implementing monetary policy as a sovereign.  Unfortunately for Cyprus, neither of those two desirable levers is at their disposal as part of a unified currency.

I think that puts Cyprus in uncharted territory.  In a way, having no levers puts Cyprus at the full mercy of the decisions made by the monetary union as a whole.  The union has free capital flow (for now) providing it with flexibility in exchange rates and monetary policy.  Cyprus, on the other hand, is now singly focused on stemming the exodus of cash when its banks reopen.  But that cash is denominated in Euros.

By restricting the mobility of Cyprus Euros, do you not create a second class of Euros – those that are mobile and those that are restricted?  And shouldn’t the restricted class of Euro’s be worth less than those maintaining their mobility?  And since Cyprus has no fortuitous levers at its disposal to find equilibrium, won’t this imbalance persist?  And, by the way, doesn’t whole idea violate the European treaty forbidding the use of capital controls by any country within the monetary union?

To me, this is a troubling crack in the facade; both from monetary and a legal perspectives.  History may look back at these “Hail Mary” attempts to save the common currency as the very seeds of its demise.


The Mouse That Roared

By now, most everyone is familiar with the weekend bail-in of the Cyprus banks.  Cyprus…  that little mouse of an island with about 1 million citizens.

From Goldman Sachs, here is a bullet-point summary of the action:

  • Over the weekend, Cyprus and Troika agreed on a rescue package with the following key points:
  • €10 billion total rescue package.
  • A tax on deposits, expected to yield €5.8 billion, which has the following characteristics:
    • 6.7% tax on deposit amounts < €100, 000.
    • 9.9% tax on deposit amounts > €100, 000.
    • Deposit amounts are recorded as of Friday close (March 15) and apply to all deposits in Cypriot Banks in Cyprus (across currencies, type of customer account). They do not apply to customer deposits of Cypriot banks held outside of Cyprus (the two large Cypriot banks both have a presence in the UK, for example).
    • Cypriot bank operations in Greece will be taken over by Greek banks, at no cost to the Greek tax payer. This is important as the large Cypriot banks operate a substantial portion of group assets in Greece.
    • In exchange for the tax, the impacted depositors will be granted shares in the Cypriot banks.
  • Tax changes, where (1) the corporate tax rises to 12.5% from 10% and the income from deposits to be taxed at 20-25%.
  • Bail-in of junior debt is expected to take place, however overall impact is limited by a low balance of outstanding securities.
  • Commitment to downsize local banking sector towards EU average size (in relation to GDP) by 2018.
  • A privatization program which is expected to contribute €1.4 billion.
  • Russia will participate, but to a small extent (exact amount / type unclear).

As a result of these actions, even deposits falling below the deposit insurance maximum will be taking a haircut.  ATM’s in Cyprus are empty and the banks are on holiday until Thursday at the earliest.

General reaction in the media has run the gamut from moral indignation to righteous rage.

  • How can government force savers to disgorge a large chunk of their savings?
  • What do you have left when the rule of law can be overturned by edict?
  • What are the implications for property rights of the individual?
  • How can we accept this financial repression of middle and lower class savers?

Feel sorry for the Cypriots.

Except the above questions were not intended to apply only to Cyprus.  They should have been asked years ago when the US Federal Reserve decided to hold interest rates at zero.

Zero nominal rates means negative real rates; forcing savers to disgorge their savings to inflation.  Artificially forcing interest rates to zero is an edict by an unelected central bank.  Hardly the rule of law.  And what are the implications for property rights when inflation backhandedly chips away at your property’s value? Finally, here, in the good-ol’ US it is the lower and middle class saver that is being financially repressed by being paid nothing on their savings.  Think of the retiree trying to make his savings last for the rest of his life.

I somehow missed the moral indignation and righteous rage when these policies were implemented on our shores.

I guess if you implement financial repression quietly and over time, few people notice or care.  Yet, if you overtly and immediately bring about the repression, you make global headlines and become the target of global derision.

So Cyprus is the mouse that roared.

Pay no attention to the whispering gorilla.