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The Cyprus Disaster

I have been slow to write about the Eurozone crisis of the moment, Cyprus, for one important reason – I didn’t understand it.  I read about how the big banks became under-capitalized and as the central government contemplated default like so many other European nations and thought it was about the same as we’ve seen repeated in far too many nations.  Then, it got weird.  What was so hard to understand?  It was the way the European Central Bank (ECB) put the hammer down that pretty much forced a run on Cypriot banks and guaranteed a major depression.  Was there something in this that I missed?  Or was the ECB really that unbelievably stupid?

After looking this over for a while, I have come to a very frightening conclusion – the ECB really was that stupid, and more.  This isn’t about Cyprus anymore, it’s about how the ECB is unworthy of any faith at all.  If that scares the Hell out of you, welcome to the club.  I certainly didn’t want to come to this conclusion, but here it is. It all starts, like everything Euro, with Greece …

Cyprus1Cyprus has fared very well through the economic crisis because it set itself up as a Eurozone member with a key difference – it’s a tax haven with a tendency to look the other way if necessary.  On this resource-poor island still divided by a Turkish occupation the major industry became banking on the fringes of the developed world.  Deposits in Cypriot banks were about 8 time the total GDP of the island, much of it from Russia (and often considered sketchy).  About 20% of the economy comes from being something like the Caymans of the Mediterranean.

But with the winding down of the Greek crisis, a major problem developed.  Greece has been Cyprus’ only real friend through the generations-long crisis with Turkey, and Cypriot banks have invested heavily in Greek debt as a result.  So when Greek bonds were refinanced with a 70% default last year (and anyone who calls this a “haircut” should not be listened to) it hit Cyprus hard.   Their banks were suddenly undercapitalized and their own bonds came under attack.

Enter the ECB to save the day!  Only the ECB didn’t bother to come in with the hundreds  of billions of Euros that they promised to Italy or Spain – no, on the €15.8B needed to shore things up, the ECB said they would give €10B and Cyprus would have to come up with the other €5.8B.  The difference was pocket change to the ECB, but it wasn’t coming.  And on top of it, they insisted that Cyprus “tax” their largest asset – bank accounts – more or less seizing whatever they needed to make up the balance.

Think about this for a moment – if you are sure that the government is about to seize 10-30% of the money you have in the bank, there is one thing you can do and that is to remove all the money you can from the bank immediately.  It’s called a “panic” and any sensible banker would do anything to prevent it, especially given that the immediate problem was that banks were under-capitalized to start with.

cyprus2The Cypriot Parliament refused without a single vote in favor for one very good reason – it spelled the end of the banking system on which they rely.  But it was too late and the damage was done.  Cypriot banks were closed for 2 weeks while it was sorted out, meaning that people had zero access to their money and couldn’t buy food, pay rent, or anything.  The banks opened with strict controls on what could be taken out last Thursday.  The lack of a major riot is a testimony to the patience of the dear people of Cyprus.

If this wasn’t stupid enough, consider that while banks were closed in Cyprus their branches abroad, such as in London, stayed open.  That Russian money parked safely in a Euro denominated semi-blind account?  Oh, you can bet that as much of that fled as possible – but this hasn’t been tallied yet.

But it gets even worse.  As part of the currency controls in place to prevent banks from bleeding further, there are limits on how much can be transferred from Cyprus to the rest of Euroland.  The island has been made into a junior partner of the Eurozone.

Think about this for a while.  While the tax on all bank accounts didn’t go through, access to the money is severely limited and something horrible was nearly forced on them.  If you were an ordinary Cypriot, where is about the last place you would put your money right now?  What if you were a Russian?

A bad situation was made much, much worse by a very stupid decision compounded daily by even more stupid decisions.  And the basic promise of the Euro, that all members were equal, has been violated.  What happens when it becomes convenient to isolate Italy or Spain?  Or, for that matter, France?

Banks in the entire Eurozone are now suspect and can expect foreign investors, as well as locals, to be much more careful, making capital even harder to raise.  In essence, the Euro has already stopped existing as we once knew it.  It’s hard to see how it survives this series of insanely boneheaded moves by the ECB.

That’s what I’ve come to understand, at least.

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14 thoughts on “The Cyprus Disaster

  1. Calling this the end of the Euro is premature, but it was “unbelievably stupid” for certain. Cyprus always has been a special case in the Eurozone and its admission in 2008 baffled many people. Isolating it is not likely to be seen as a precedent by the larger troubled nations such as Italy and Spain. Nor is the tax on deposits likely to be seen as a standard policy to be inflicted on troubled nations, this simply could not be implemented in Italy for example. But this relatively small event was blown into something much larger and does shake confidence badly across the Eurozone. We do not know yet how it will play out and how weary Europeans have become of the constant drama but it has to be draining.

    • I say it’s the end of the Euro because the promises of unity have been broken. More to the point, the ECB has been slow to print more Euros because they see their job as defending the value of the currency – but to Cyprus, at least, it’s worth something different. Breaking those promises has to shake faith – and as Adam Smith noted all money is in the end a matter of faith.
      I hope that the larger nations see Cyprus as an anomaly, but I think they may not. Any reasonable Spaniard must think about keeping a few thousand Euros on hand now in cash – that’s money out of the system. The implications will play out for months.
      My main point is that this is going to be far more expensive than the 5.8B that it would have taken to just bail out Cyprus all together in the first place.
      I hope you are right and this is not the end of the Euro as we know it. I really hope I am wrong here. But this was a major turning point in my mind – but yes, it’s the minds of the average Italian or Spaniard that matter more.

  2. I think you said before that they were starting to panic, is this what you meant by that? It does seem like a very bad way to handle the crisis but isn’t each nation supposed to do what they can for themselves first? I guess I have more questions than answers. The only other thing I worry about is if the Euro is really in trouble what that means for the US. This has been going on for so long it seems like it really has nothing to do with us at all.

    • So many questions! 🙂 Let me do this in order:
      I did write about the sense of panic rising, and you’re right that this is an expression of that. I noted the rising panic at the Davos Conference and more explicitly later discussing worldwide intervention by central banks. Yes, there is a sense of growing panic.
      As for nations handling this by themselves first, that has been the standard – although it’s better put that they get as many pounds of flesh out of them as possible. That’s the nature of austerity in Europe, and it hasn’t been working. This time they did try to do something different, which was interesting, but it was so poorly thought out. I guess you are right to mention that this is still standard “each central bank on their own” policy because they have not actually abandoned anything even if they are more squishy on austerity – which everyone knows isn’t working.
      How will this affect us? Most big banks here took steps to insulate themselves from Europe a long time ago. What I worry about are all those Credit Default Swaps that JP Morgan (and to a lesser extend Morgan Stanley and Goldman Sachs) have invested in. Some of them are insurance against European defaults. So far the defaults have been carefully controlled and not enough to kill anyone (except, apparently, Cyprus) but we can see how the dominoes fall slowly. If this turns into a big Euro failure I would think JP Morgan is on the hook for a LOT of it, and as noted here they are not as healthy as they should be to start with.
      Good questions, all worth another 800 word essay frankly. We have entered a new phase of Euro problems and it is worth thinking through. I think that at the very least any calculations of the Worst Case Scenario have to be re-done.

  3. Can I ask a stupid question? What would it take for them to solve the Euro problems once and for all and be done with it? I am tired of reading about this.

    • A very good question! How do we push the big ol’ Reset Button?
      I’ve talked about this a lot, but there has to be some kind of debt forgiveness involved in this. That also means that the ECB will wind up printing more Euros, but we came to these conclusions long ago. They would also have to have some agreement as to how things will be different going forward – that is, we really did reboot the system and we’re starting clean (and you can’t expect more bailout in the future!).
      But it is something like that, for sure. There HAS to be some kind of debt forgiveness in here. I proposed the auction method of doing it, which is to say letting some market forces dictate what is written down, but that may not be enough. And what is done has to take into account both the moral hazard (“we’re not doing this again”) and the problems in the union that allowed it to happen in the first place (borrowing way ahead of their capacity).

  4. A well written article that hits the highlights quickly. The first casualties are coming in already and today it is Slovenia. I would expect them to be “isolated” as you say just as quickly as Cyprus was. The contraction of the Eurozone is starting already. Expect a full breakup in short order.

    • Thank you. Yes, this does seem like the endgame forming. It is sickening to watch. Here is an article from the Telegraph on Slovenia. The headline that says Slovenia “will not be the next Cyprus” says it all, in that what has to be denied most vociferously is usually the truth.

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