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

-29/03/2013

[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 ...>