News in Charts: A template for a bank run-Cyprus Bailout

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The latest rupture in the euro area banking crisis has been characterised as “unique”; specific to Cyprus bailout; without parallels elsewhere in the euro area, etc. But in fact it is just the most recent in the on-going series of unfortunate events, each of which has been described in a similar way. At the time of the Greek PSI, Fathom highlighted the fact that one of the main losers in that deal would be Cyprus. Now, that loss is reverberating around the Cypriot banking sector to disastrous effect – at least in Cyprus itself, and potentially more widely across the euro area as a whole. There is an underlying structural problem playing out through Greece, Spain, Portugal, Italy, Ireland and now Cyprus: the fact that the currency union stands in need of a banking and fiscal union. The absence of such a thing led to this crisis and all the others. And the way the current crisis has been dealt with means that important red lines have been crossed, which are potentially significant for the whole of the euro area.

The European Debt Crisis illustrated in EUR/USD spot rate from 2008-2012
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The crisis in Cyprus has forced the euro back into the spotlight: first, with renewed concern that the wider euro crisis was not over, and now with renewed relief that a deal has been stitched together at the last minute. But the relief is misplaced and will be short-lived, since the “doom-loop” undermining the euro – between insolvent banks and their indebted sovereigns – has not been broken, but emphatically reaffirmed. Markets appear to be relatively sanguine so far about the wider implications of the Cypriot “bail-in”; we are not.

Cyprus is tiny, but the way its trauma is being handled illustrates the muddled and inadequate approach that euro area policy makers have adopted across the board since 2009. The correct solution for Cyprus is also the only way for the euro to survive in the long term. It would have involved direct recapitalisation of Cypriot banks by the euro area as a whole – in other words, fiscal transfers through the conduit of a banking union. But that solution has been firmly rejected. Instead, the agreement involves a further loan to Cyprus’ already over-extended sovereign, under new and particularly stringent conditions: not just a commitment to future austerity, but a haircut to be imposed on large depositors at Cypriot banks.

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The haircut on bank deposits makes a bank run in Cyprus a virtual certainty – given free access to their money, depositors are extremely likely to withdraw all of it. So they will not be given free access. Cypriot banks have reopened, but with capital controls imposed. And the Cypriot banking sector, the mainstay of its economy alongside tourism, is dead in the water. The long-run prospects for its economic growth are correspondingly bleak.

Cyprus’ legal status within the euro is now questionable, and will remain so as long as capital controls are in place. On the ECB’s website, under the heading “Stages of Economic and Monetary Union”, Stage item 1 reads:

“Complete freedom for capital transactions”;

which is explained in more detail as follows:

“…the European Council decided in June 1989 that the first stage of economic and monetary union should begin on 1 July 1990. On this date, in principle, all restrictions on the movement of capital between Member States were abolished.”

That principle has now been abandoned with respect to Cyprus. The capital controls are intended to last a matter of days or weeks – but similar controls have been in place in Iceland for years (though Iceland has its own currency).

The thinking seems to be that Cyprus has been uniquely feckless and deserves to be made an example of, to encourage the others. There are echoes here of the way the Northern Rock crisis of 2007 was handled in the UK. Policy makers were keen to dispense harsh moral lessons, in order to avoid the “moral hazard” that would flow from bailing out Northern Rock at the taxpayers’ expense. From the lofty position on their moral high horse, they failed to notice the impact that even the threat of letting Northern Rock collapse would have on other banks and the economy as a whole: a failure that was repeated with disastrous consequences with the Lehman fiasco a year later. Now, according to eurogroup President
Dijsselbloem:

“…we’re going down the bail-in track and I’m pretty confident that the markets will see this as a sensible, very concentrated and direct approach… It will force all financial institutions, as well as investors, to think about the risks they are taking on because they will now have to realise that it may also hurt them.”

The time to worry about moral hazard is in the build-up to a crisis, or once that crisis is over
– not while the crisis is upon you. But it seems that euro area policy-makers have yet to understand this. At present, they are congratulating themselves for having provided Cyprus, in the words of German Finance Minister Wolfgang Schaeuble:

“…with the best chance of getting back on its feet”

But the current policy prescription for Cyprus will crush an economy that is already on its knees. It will force Cyprus out of the euro area in the end, damaging its economy irreversibly along the way. And it increases the risk of an implosion of the currency bloc: it could trigger accelerated deposit flight right across the peripheral economies, which in turn could lead to a systemic threat to the euro area banking system as a whole.

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Meanwhile, on a much longer timescale, in Cyprus as across the peripheral economies of the euro area, the inexorable logic of debt deflation under fiscal austerity with a fixed currency is already taking root. Without a fully-fledged banking union, that logic will eventually force all of those economies out of the euro. The default that will follow will be bigger and far more damaging than the alternative – a managed, orderly process within the euro. If it happens, it will result in a global credit crunch and recession, and the end of the euro project.