Cyprus and Capital Controls

Having failed to agree a bank resolution regime more than four years into the Eurozone banking crisis, the EZ authorities have, at the second attempt, come up with a resolution of the Cypriot banks. The haircuts of uninsured bank creditors appear to be 60% and more.

After a bank resolution, the surviving banks are solvent. Naturally, depositors may feel sore, and there could be deposit flight as soon as they re-open, even where the haircuts have been severe enough to make them adequately capitalised again. But not to worry, the central bank is there to deal with irrational deposit flight. It is after all the lender of last resort.

But lo and behold, the Cypriot government has imposed capital controls – even insured deposits not facing a haircut are restricted. But since the written-down assets of the surviving banks are now in excess of their liabilities (they have been resolved) these assets will be money-good at the central bank.

Not so apparently. If the ECB believes that the surviving Cypriot banks are now solvent, why is there any need for restrictions on depositor withdrawals? Is the ECB prohibiting liquidity provision through ELA after a bank resolution to which it has been a party? 

Of course the haircuts may, in the eyes of the ECB, be inadequate to ensure solvency. In which case why is the deal not modified further? Capital controls effectively create an inconvertible currency trapped in Cypriot banks, a precedent likely to be remembered when trouble strikes elsewhere. Do re-opening US banks decline to release deposits after the Feds have done their work, for the want of a lender of last resort?

Simon Wren-Lewis on Buti and Carnot

Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back.   In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.  

But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB).   In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress.   This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland  and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory.   (Some thoughts from the time here.)   In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.  

(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests.   Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)   

The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR.   The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework.    This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.  

Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.

Political asymmetries and EMU

In a must-read article, Chris Pissarides states that “far from the currency bloc acting as a partnership of equals, it is a disjointed group of countries where the national interests of the big nations stand higher than the interests of the whole.”

This sums up perfectly where the European project is today. Indeed, there isn’t even solidarity among the smaller countries, as Malta and Luxembourg seek to distance themselves from Cyprus, reminding us of many similar protestations by individual PIIGS in the past, Ireland included. Not that it did any of them any good.

Was it not bizarre to see so many anti-German posters in Nicosia last week, when by all accounts it was the Cypriot President (among others) who wanted to see small depositors hit? Actually, no, it wasn’t. We have seen several statements by German politicians saying that the Cypriot business model is dead, and I’m sorry, but irrespective of the rights and wrongs of the issue this is simply unacceptable. The IMF has the right, and duty, to opine on such matters. So does the ECB, which is supposed to care about financial stability, whatever about how it behaves in practice. Perhaps one could find a rationale for the Commission, or maybe even the Eurogroup, to express an opinion on matters such as this. But an individual member state? Formally speaking, and in any club such formalities matter, it’s none of their business. Even if it is an election year.

The EU is supposed to work according to a set of well-understood principles. If we want to re-regulate the banking sector, and we should, then the recent decision to cap bankers’ bonuses is an example of how the system is supposed to work (again, irrespective of the merits of the issue). There are proposals, there is a vote, there is a decision. Fine. I’ll have more of that please.

But that is not what we are seeing here.

It might be less difficult to swallow if the German government were caped crusaders seeking to bring the entire European financial system to heel. But we all know who has been undermining the drive to have a meaningful European system of banking supervision, and it isn’t Cyprus. And is Mr Schaüble really going to try to prevent German banks from touting for business in that island, as the FT recently reported? I don’t think so. None of this means that Merkel and Schaüble are any worse than anyone else’s politicians, but if you are the arbiter of other countries’ fates, and you aren’t any better either, then there’s going to be a backlash. Which is terrible news for Germany in the long run.

My quote of the week is from another must-read article, this time by Wolfgang Münchau, who says that

I have believed for some time that it is impossible for Germany, Finland and the Netherlands to be in a monetary union with Cyprus, Greece and Portugal. Either the two sides agree to adjust more symmetrically, politically and economically, or this experiment should end.

The argument about economically asymmetric adjustment has at this stage been done to death, and almost everyone understands it, although the German government remains resolutely, proudly, and vocally, macroeconomically illiterate. Another reason why anti-German posters at mass demonstrations are something that we will have to get used to, which is tragic. But Wolfgang’s point about politically asymmetric adjustment is just as important, and gets to the heart of the matter.

When the EU club works according to its rules, people accept the outcomes, but in crises policies are made on the hoof, and it is the powerful who call the shots. This is inevitable, but it is also very dangerous, especially since the decisions that are made at times like this have a much bigger impact on peoples’ lives than anything that typically comes out of Brussels. We have been in crisis mode for much too long now, the crisis shows no signs of going away any time soon, and the political asymmetry is becoming intolerable.

A meaningful banking union, that had the power to stick its nose into the German banking system, and had a set of ex ante mutually agreed principles regarding how to resolve banks in all member states, would help reduce political asymmetries. More expansionary monetary and fiscal policies would help make economic adjustment more symmetric. I suspect we’re going to get neither, in which case we need to end the EMU experiment before it drags the broader European project down with it.