Thursday, March 21, 2013
Will Germany Turn Europe Into Latin America?
The headline in today's Journal is "Merkel's Hard Line, Vilified In Nicosia, Cheers Germany". Some quotes:
"Cyprus lives off a banking sector with low taxes and lax regulation that is completely out of whack. As a result, Cyprus is insolvent and no one outside of Cyprus is responsible for that…We've taken measures in all countries to protect ourselves against contagion effects."
--Wolfgang Schaueble, Finance Minister
"Merkel has nothing to lose in Cyprus."
--Ulrike Guerot, European Council on Foreign Relations
Germany is happy about the Cyrpus banking crisis because it will punish Cypriot sinfulness. I guess the sin is that the eurozone is no place for an offshore banking center/tax haven, which is debatable. But that decision should have been made before Cyprus was admitted into the eurozone. Now its banks have EUR 50 or 60 billion in euro-denominated deposits which Germany wants it to default on. The Journal says that "one reason that Berlin is taking such a hard line on Cyprus now is that it sees the country's crisis as a unique opportunity to end its reliance on tax refugees". This is punishing shoplifting with the death penalty.
Germans are very skilled at making things and being thrifty. They are economically admirable in every way except one: they have never accepted modern capital markets. They have resisted anglosaxon capitalism for forty years, and they still don't accept it. Germany (like France) believes in intermediated financial markets which can be controlled by the authorities in order to ensure financial stability. They don't trust independent market actors like hedge funds, US investment banks or rating agencies. You can make an argument that they are right, but it's way too late. They lost that battle and global finance is now substantially anglosaxonized.
A large percentage of European capital flows today are disintermediated, especially cross-border. And anyway, foreign banks are no more controllable than hedge funds. The creation of the eurozone by itself substantially reduced the power of national authorities. Consequently, the European capital market is now more powerful than the European national authorities. Germany doesn't like this for good reasons, but it is a fact that she can't change. Causing Cyprus to default is not a good way to deal with this issue.
So where's the black swan here? What did everyone miss? The markets knew that the Cyprus banks were insolvent because of Greece’s default. They knew that Cyprus had billions in offshore deposits. They knew that the Cypriot political system (like Greece's) is politically incapable of accepting any form of IMF-style austerity. Everyone has known about this witches' brew. But, everyone figured, the Cyprus problem is a rounding-error, and Europe always manages to kick the can down the road. It’ll get fixed. That’s certainly what I’ve been predicting.
What we didn't know was that Germany wants a crisis in Cyprus. Germany wants Cyprus to default on its bank deposits. That wasn’t understood until now. That’s the black swan. In retrospect, we can see the explanation: bailout fatigue on the part of the thrifty German people; the desire to disallow the enabling of tax evasion by a eurozone member; and outspoken distaste for the Russian kleptocracy. But the truly dangerous part of the German rationale is the mistaken opinion that a Cyprus banking collapse is manageable. This is the same stupid complacency that led to Lehman.
A Cypriot banking collapse will have unpredictable consequences; it’s a shot in the dark. It will inevitably create contagion--maybe not immediately, but eventually. Credit committees work on schedules. If Cyprus goes, risk limits for southern Europe will be reduced. Investments, deposits and capital flows will be redirected. Southern European banks will lose deposits not just from foreigners, but also from domestic investors and corporations.
A deposit freeze affects every bank, not just the weak. A Spanish millionaire is no safer in Banco Santander's headquarters office in Madrid than in the tiny caja down the street. Remember: if Cyprus blows up, Cypriots with deposits in foreign banks will not be affected. The key is getting your money out of the country.
This is a classic Latin American banking discussion. I’ve sat through scores of them. Southern Europe is at risk of going back to a Latin American-style financial system. Latin American depositors instinctively understand that you must keep your company's money and your family's wealth in a hard-currency deposit in a big bank in a strong country. Southern Europeans used to know this: it was called a numbered Swiss bank account. They are relearning this lesson. Let me be clear about what is happening here: we already have within the eurozone billions of nonconvertible euros. That’s a word you haven’t heard lately, unless you live in Venezuela or Cuba.
The West has spent the last sixty years building an institutional framework to allow global trade and capital flows. This has meant the dismantling of currency controls, capital controls, trade barriers and barriers to foreign investment. As this structure has been built, lessons have been learned: Don't lend or borrow foreign currency. Don't build up short-term foreign debt. Capital inflows can go both ways. The eurozone was supposed to be an enhancement to the globalization of finance. It was supposed to do for the eurozone what the dollar zone has done for the Americans.
If eurozone bank deposits now become subject to sovereign risk, that will reverse the whole process. No one can be that reckless, and the Germans aren't supposed to be reckless. They are what economists call "a serious country". Let's hope they stick to that tradition.
A Brief Note on Deposit Freezes
Deposit freezes almost never end well. They are imposed during banking crises in order to stop bank runs. Unless the reason for the lack of depositor confidence is removed or the deposits are rescheduled, the run will resume when the freeze ends. The only way to end a freeze without default is to restore confidence with a guarantee from a creditworthy guarantor backed by unlimited resources. Unlimited resources means a printing press.* There is only one such entity in the eurozone, the ECB, or the ESM backstopped by the ECB. There is no evidence that anyone is even discussing such a resolution. Germany wants a default.
*The US ended its deposit freeze in 1933 by forcing many banks to default and then guaranteeing the rest. Millions of innocent people lost their savings.