A Question of Trust; Cyprus, the Banks and the EU

26 Mar

[My first piece of political commentary. Please be kind.]

The last few weeks have seen worrying developments in Cyprus, developments that are illustrative of both the problems the EU will likely experience in coming months and years and of the complete failure of the political leaders in the EU to understand the impact their polices have on long-term growth. As such, it is worth study by anyone interested in political developments.

A general narrative of the crisis can run something like this. In order to help fund the bailout the EU (mainly Germany) was prepared to offer Cyprus, the locals were expected to impose a tax on deposits in local banks. What that means, in practical terms, is that bank accounts over a certain level (national and foreign alike) were going to be raided to help fund the bailout. This promptly caused a major crisis of confidence in the island’s extremely important banking sector, as well as runs on the banks by small investors (which caused chaos when the banks were shut and sellers stopped accepting credit cards and cheques.)

[This narrative may not be completely accurate, but political narratives seldom are.]

As a general rule, taxes are paid on money one earns – once. You might be taxed £10 out over every £100 you earn, but the remaining £90 is yours. Most people promptly put it in the bank, where it can earn interest – on the assumption that it will be safe there. This is not a foolhardy assumption under normal circumstances; a bank is generally harder to rob than a house and has insurance allowing the bank to recover from a robbery, or at least repay the people who put their money in the bank.

This also puts money into the local economy. To use a set of simplified figures, if ten people loan £100 to the bank each, the bank has £1000 – which it can then loan to someone else, collect the interest when the loan is repaid and then use it to give interest to the original people. What this means (practical terms again) is that the banks rarely have vast sums of money on hand. The existence of your money in the bank is, to some extent, a legal fiction. What this means is that banks rarely have enough capital on hand to pay if all of their customers suddenly start demanding their money back.

One or two people demanding their money – or even several hundred, given the size of the average bank – isn’t a problem. If, however, confidence in the bank is shattered, every customer will want their money back before it is too late. This panic creates a run on the bank, which spurs others to demand their own money back … and eventually collapses the bank. Part of the reason European Governments have largely underwritten small investors is to prevent such a scenario from destroying a European bank.

This may seem absurd; bankers talk of billions of pounds (or dollars, or whatever) while the average saver may have little more than £10000 in his account, if that. However, such figures add up quickly. If we assume that a bank has 100000 customers, each with an average saving of £1000, it becomes clear that the bank actually holds £100000000. That is not a small amount of money.

What customers demand from their banks is, above all, safety – a guarantee that their savings won’t be plundered by the bankers. Who in their right mind would put money in a bank with a leaky safe or cashiers with greedy hands? And tell me – who would put money in a bank when the government of that country, egged on by the EU, has seriously proposed to loot it to pay off a foreign debt?

Cyprus may not go as far as the doomsayers have been predicting. But the damage has been done. The country’s banking sector, which is a major part of the economy, has lost the trust of its investors.

Every so often, if I may digress a little, there is public and political anger at the bonuses bankers receive, followed by calls to strip them of their golden parachutes – rewards, in the public mind, for making millions while costing the country billions. Legally, however, the bonuses are untouchable. The bankers cannot often be forced to surrender their gains, no matter how politically expedient it is to do so. If it were to happen, it would dent the faith of businesses in the rule of law. If a contract can be overridden at a government’s whim, then no contract can be said to be truly secure. This is the death knell for a free market economy.

You cannot retroactively declare something illegal without undermining your justice system. Writing laws to forbid such bonuses in future might make sense; God knows that bankers get paid more than the average working person in any case. Slamming them for acts, no matter how shameful, that were not illegal at the time is asking for trouble. Anything can be declared retroactively illegal. Anything at all. Just ask Cicero.

Trust is an important part of maintaining an economy. It is also something that is in short supply outside the West.

If you look at Third World countries that stagnate, despite vast infusions of foreign aid, they tend to have one thing in common. There is no non-family trust. People do not trust outsiders, other people who are not members of their own family. And why should they when there is no recourse to recover one’s money if it is lost? Or if someone related to the nation’s leader can take whatever he wants, without paying. Or if the size of the bribe you pay is what determines what, if any, justice you receive?

These countries have no trust – and, really, why should they?

What is this likely to mean for Cyprus – and the EU as a whole? Right now, the Government of Cyprus is working hard to prevent money from flowing out of the country … having woken up to discover just how badly the EU has sideswiped them. That isn’t going to calm future investors, is it? Why would anyone put money into a black hole? Even if the tax on deposits is completely scrapped, the damage has been done. The can of worms has been opened. Use whatever metaphor suits you best – a very dangerous line was crossed over the last two weeks. The long-term repercussions are going to be disastrous.

The EU has been working hard to claim that they are merely collecting Russian money – with a strong implication that the only reasons Russians would put money in Cyprus is for criminal reasons. (The Kremlin has been cracking down on Russians holding offshore bank accounts recently; make of that what you will.) This is untrue; all businesses that deal in Cyprus, national and international, run the risk of losing large chunks of their cash. Even if this was just a once-off, it would still do irreparable damage to Cyprus’s reputation as a safe investment. Worse, there is absolutely no guarantee that this couldn’t either be repeated – or spread.

Now that this precedent has been allowed to stand, what guarantees can you offer that savers in Britain, France or Germany won’t be hit too?

Brussels has been working hard to convince everyone that this is indeed a one-off, that it won’t be repeated. Does anyone feel like trusting them to keep their word?

<FX: clocks ticking, crickets chirping, owls hooting, etc …>

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19 Responses to “A Question of Trust; Cyprus, the Banks and the EU”

  1. Larry March 27, 2013 at 11:21 pm #

    More and more I have become convinced that Liberalism/Progressivism is a form of mental illness. Their socioeconomic philosophy appears to be based on feelings instead of critical thinking. In America we suffer under one of the most corrupt/progressive governments in our nation’s history. Five years under the current regime has produced no job growth, a median annual income that is nearly 10% lower than it was 5 years ago! Thankfully, we are a well armed populace and if things get worse we can return to a Constitutional Republic.

    • chrishanger March 28, 2013 at 1:15 pm #

      I think it’s when wishful thinking is allowed to override pragmatism – which is quite easy, when one doesn’t appear to have anything at stake. (See all the thinkers who look at the Palestine situation and propose completely unworkable solutions that sound good.) Then there’s the desperate attempt to keep playing musical chairs until it’s too late… Chris> Date: Wed, 27 Mar 2013 23:21:19 +0000 > To: christopher_g_nuttall@hotmail.com >

  2. Tamara March 28, 2013 at 1:09 am #

    Let’s look at a few things about Banks…
    – Banks offer their services not for free…They have stock holders too…
    – Currently interests given back to the original money owners are less than the actual inflation rate (at least in Germany)… The only reason to put your money in a bank is for convenience
    – Banks work with the Money they get not only by giving loans… They buy and sell stocks and often enough they loose the money
    – Banks pay salaries and high ones too…well that money must come from somewhere

    It’s true that the EU will have an effect on how people trust banks but to be honest I and a lot other people lost their trust in banks a long time ago. We had so many scandals involving banks in the last 10 years why should I trust any of them? I have a bank account too because I need an account for receiving and transfering money.

    Politics is a different thing. I always hear people do not go to votes because they lost interest in politics that’s not entirely true. People do no longer believe it makes a difference who they vote. That’s the sad truth.

    What we need is a complete make over of laws and taxes. It would be even better if we could do this EU wide but that would cost a lot of people their might and that won’t happen…At the moment all they do is patching holes….

    ..my 5 Cents of politics…

    • chrishanger March 28, 2013 at 1:13 pm #

      True enough. Problem is – the banks won’t be able to pay their stockholders either if they lose the public’s trust. Chris > Date: Thu, 28 Mar 2013 01:09:19 +0000 > To: christopher_g_nuttall@hotmail.com >

      • Barb Caffrey March 30, 2013 at 3:42 pm #

        There have been some really good books about the problems with international banking, Chris. There are bad problems on that side that have come with a lack of standardized regulation; the banks are playing both ends against the middle, which is quite legal even if often unethical, and innocent people (usually people at the middle class and below) get shafted while the extremely wealthy know how to shelter their money against all comers. (Those in between the middle class and extremely wealthy often get forgotten. Some of them know how to shelter money, also. Some do not. Most of the latter end up shafted in the same way the middle classers and below have been, and it’s wrong.)

        However, the problem with Cyprus is also bad because those aren’t the type of regulations that are actually going to help anyone. Regulations that have helped, such as in Iceland, go after the bank owners and/or stockholders who’ve committed outright fraud which is illegal under the laws of the country, province, or state in question. (As you say, retroactive laws don’t get us anywhere. But passing sensible laws that make sense would. Enforcing the laws already on the books should be the highest priority — it hasn’t happened in the US, where the “big banksters” have recouped all of their assets, if they lost anything at all during the 2007-8 meltdown, but middle class people who’d invested their life savings lost a significant portion of them — or worse, *all* of their life savings — because they were told their holdings were “safe” even though they weren’t, and trusted the people running their retirement portfolios to do a good job. Middle class people, in the main, know nothing about finance, so they trust those who do to do a good job. They didn’t, those people who misled them didn’t have to pay *any* price for their malfeasance in the main, and that’s plain, flat wrong.)

        There were some real problems with the Isle of Guernsey (another financial sector) when middle class people had their assets frozen for no good reason. Some of them had to wait two years to get their money. (Read Michael Casey’s “The Unfair Trade” for further details. I reviewed it over at SBR a while back, and it is extremely insightful in explaining exactly what went wrong and how we can start getting things realigned so the middle class can again have a say in our worldwide economy). It sounds to me that Cyprus might’ve been trying to prevent this in a weird way, but what happened on Guernsey had to do with upper management and some stuff with the UK that hit depositors on Guernsey oddly (even though most of them were UK residents, they weren’t treated as such by Casey’s description — you may have read some of this, for all I know, as the UK newspapers widely reported this at the time).

        At any rate, I agree with you that the EU’s attempt here was ill thought-out and did much more harm than good. I also think it’s very strange that here we have so much unwieldy bureaucracy throughout the world that common sense solutions, such as Casey’s, do not get heeded because there are just too many hoops to jump through — even though every middle class person in every country Casey talked with said the same, exact things. (Casey is a well-known financial journalist with an extensive economics background. I trust his reporting.)

      • chrishanger April 1, 2013 at 9:10 am #

        No arguments there. Whatever happens, someone is going to get messed up. Chris > Date: Sat, 30 Mar 2013 15:42:43 +0000 > To: christopher_g_nuttall@hotmail.com >

  3. Terry March 29, 2013 at 3:08 pm #

    I would not want to be living in california either Chris…they are gonna default on their debt then what next? Another Cyprus…well written

    • chrishanger March 30, 2013 at 1:19 pm #

      I know – I’m not sure what will happen there. Cali is part of a much larger country. Will the Feds try to bail out the state? It might make sense to try, just to deflate the abscess without it exploding, but I’m not sure it is possible – is there that much money in the US? Chris > Date: Fri, 29 Mar 2013 15:08:11 +0000 > To: christopher_g_nuttall@hotmail.com >

      • Caleb Wachter March 31, 2013 at 2:41 pm #

        What we are watching is an economic apocalypse, plain and simple. The entire Western World has become bloated after decades of ‘progress.’
        And as with apocalypses of the cinematic variety, a world will emerge and people will inhabit it. It just won’t look anything like what came before it, in many ways.
        The main problem with bailouts like for CA and MA in the USA is the domino effect. But no matter how much money a nation has, if it takes from those who were responsible and gives to those who were not, the whole institution collapses. It’s just a matter of time. Tomas Jefferson put it more eloquently than that, and he did so nearly two and a half centuries ago.
        A lot of things our generation grew up taking for granted are going to be stood on end.

      • chrishanger April 1, 2013 at 9:02 am #

        I wish I disagreed with you. Part of the problem is that the EU economies are fundamentally different and the Euro locks them into a straightjacket, making it harder for them to adapt to change. Part of the problem is that Greece et al flat-out lied to the EU about their banking position, leaving the EU with a mess when the bills finally came due. Chris > Date: Sun, 31 Mar 2013 13:41:40 +0000 > To: christopher_g_nuttall@hotmail.com >

  4. Robin March 30, 2013 at 8:21 pm #

    The terms of this bailout as they are being slowly unvield are seeming more and more draconian. The parties involved have really screwed Cyprus and possible whicever country comes next. The power exerted in these economic situations by Germany has been wholly disturbing and if I was a southern european I would be extremely unhappy. The euro as it stands is the perfect vehicle for the growth of the German economy, and they have protected their interests with disastrous consequences for the rest.

    The EU actually wasn’t involves in this as a main protaganist that actually is more then just the euro zone countries such as britain. Who I would assume would be much less incline to raid savings as the banking sector is such an important part of their economy.

    • chrishanger April 1, 2013 at 9:08 am #

      No arguments there. The problem is that Germany has elections coming up. If Merkal shows weakness, her enemies will make a big song and dance about how she’s selling Germany out to the incompetent bankers in Cyprus. So she really needs to make Cyprus squeal (which she has done). Partly, the problem is Eastern Europe’s fault. There was a LOT of deceit when those states were applying to join the EU (and a shortage of due diligence on the EU’s part.) This doesn’t excuse screwing outsiders (like British expats who have savings over there) or wrecking their own long-term prospects to appease the EU. Chris > Date: Sat, 30 Mar 2013 20:21:35 +0000 > To: christopher_g_nuttall@hotmail.com >

  5. Sithicus April 1, 2013 at 10:00 am #

    I think I’ve got an idea that could help the USA avoid the collapse. How about Tom Kratman for POTUS?

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