Yglesias Cheers a Double Betrayal of Cyprus

By William K. Black

Slate’s Matthew Yglesias writes columns about economics and finance.  Yglesias has been writing about Cyprus, and my critiques of the policies he has been proposing are the subject of this column.  The short version of the background one needs to understand the issues is that Cyprus is in a crisis and the EU is willing to bail out its collapsing banks only if Cyprus raises revenues.  The EU is unwilling to make the banks’ sophisticated creditors – the bondholders – take any losses.  The EU wanted the banks’ least sophisticated creditors – the depositors – to take losses, even if their deposits were small enough to be within the deposit insurance limit.  The reality, which the EU wishes to obscure by calling its proposal a tax, is that that the EU was insisting that depositors no longer be fully protected from loss by government deposit insurance.  The EU demand was made shortly after the EU and Cyprus’ government pledged that depositors under the insurance limit would suffer no losses. 

Cyprus’ government’s duplicity was prompted by its close ties to Russian oligarchs who deposit the funds they loot from Russia in the failing Cypriot banks.  Cyprus’ plan, therefore, imposed a hefty (6.6%) loss on (smaller) insured depositors in order to keep the percentage loss on huge depositors well in excess of the 100,000 euro insurance limit under 10 percent.

The plan was terrible for Cyprus, terrible for insured depositors, and very dangerous to banks in the European periphery (because it could spark large withdrawals of insured and non-insured deposits from such banks).  The plan was also a political failure that enraged most Cypriots into opposing the deal.  Yglesias’ response to the plan was a March 18, 2013 column praising it: “Two Cheers for the Cyprus Bailout.”

The part that Yglesias liked best about the plan was causing depositors – including the fully insured smaller depositors – losses.  The single worst aspect of a terrible plan is what Yglesias cheered.  In fairness to Yglesias, he wrote that the losses imposed on the largest depositors should have been larger and the losses on the insured depositors smaller.  He did not, however, call for Cyprus and the EU not to breach their promises not to force losses on the insured depositors.  His position was that the magnitude of the betrayal of insured depositors be reduced (“It’s perhaps not possible to entirely spare middle-class savers, but they can be cut a much better deal than this.”)  Yglesias’ one sentence summary of his position reads:  “The plan to punish Cypriot bank depositors is hideously unfair, but it contains the germ of a great idea.”

Yglesias unintentionally reveals that this conclusion rests on a mistake of fact in this paragraph:

“Ever since the spectacular collapse of Lehman Brothers in 2008 and the ensuing financial crisis, regulators and politicians have lived by a single rule: No losses for bank creditors. The common thread of every bailout has been that banks pay off their debts in full.”

I agree that too many of the bailouts have bailed out too many creditors, but Yglesias’ statement is incorrect because it is overbroad.  Depositors have not previously suffered losses, but banks have creditors other than depositors and some of them have suffered losses in bailouts.

Yglesias missed the obvious problem that having to put a “hideously unfair” plan to a vote in parliament is likely to lead to a rejection of the plan.  (At this juncture, the MPs that voted unanimously voted to reject the plan.)  How unfair and self-destructive (because of its terrible impact on depositors and banks in the periphery) a plan was the deal that Yglesias claimed contained “the germ of a great idea?”  It was such an unprincipled betrayal that the German government denounced it.

“German Finance Minister Wolfgang Schaeuble, who blamed the idea of a confiscatory tax — and by implication, the market fallout — on the unelected technocrats at the European Commission and the European Central Bank.

‘We of course would have respected the deposit insurance that guarantees accounts up to 100,000 but those who opposed a bail-in — the Cypriot government, also the European Commission and the ECB — they decided on this solution and now they have to explain it to the Cypriot people,’ Schaeuble said.”

The Germans are the über falken on making bank creditors take losses in bank bailouts, so Schäuble’s denunciation of the deal demonstrates conclusively that it is indefensible.  (Caveat: Schäuble was speaking for public consumption.  There are indications that he proposed during the negotiations to inflict a far higher percentage loss on the uninsured depositors.)

The Bloomberg reporters explained the broader concern about the deal.

“Europe’s drive to rescue Cyprus risks undermining a region-wide deposit guarantee plan, a key tenet in the battle to contain the debt crisis, and casts doubt on the ability of the weakest lenders to retain deposits.

‘This will be the death knell for an EU Common Deposit Guarantee scheme,’ Roberto Henriques, an analyst at JPMorgan Chase & Co. in London, wrote in a report to clients. ‘With this action, one of the stabilizing instruments will have been completely undermined in the current process and, in the future, we may see a very strong reaction in deposit flows in the event that a banking sector may experience stress.’

‘It is very clear in the [European] commission text that savers who are covered by deposit guarantee schemes, because they have deposited less that 100,000 euros, should be excluded from the scope of any bail-in,’ said Vicky Ford, a U.K. Conservative member of the European Parliament who is working on the law.”

These are the same concerns I expressed in my March 18, 2013 article criticizing the cynical and self-destructive Cyprus deal.  Yglesias and I wrote our articles with the same facts available to us.

Yglesias, however, thinks the Cyprus “reverse toaster” plan is “well-organized” and is essential to create desirable incentives.

“Thus far, a well-organized haircut plan—in contrast to the chaotic Lehman bankruptcy—does not seem to be provoking any dangerous financial contagion around the world. But if similar plans are to be workable in countries less weak and tiny than Cyprus, they have to be done in way that are less punitive to small depositors and put the risk where it belongs—on wealthier, presumably more sophisticated, investors who have the capacity to assess the soundness of different banks. As problematic as the initial Cyprus proposal was, it is an important step back to post-crisis normalcy.”

Yglesias is not being ironic when he calls the Cyprus deal “well-organized.”  He actually thinks it is well-organized, which is an idiosyncratic view from a journalist.  Commentators with experience and expertise have the opposite view.

“‘It looks like a botched and improvised job, and unprofessional – groping in the dark without much consideration of what sort of signal it sends,’ said Alessandro Leipold, a former International Monetary Fund official who is now chief economist at the Lisbon Council research group in Brussels.

‘That’s no way to really run a crisis.’”

Note that Yglesias does not want to pay depositors in full even when their accounts are below the insurance limit and, by law and policy, are supposed to be paid in full.  Yglesias simply wants the loss inflicted in the future on insured depositors to be “less punitive” (than 6.6% losses).  He wants to inflict losses on “small depositors” even though he (implicitly) acknowledges that they lack “the capacity to assess the soundness of different banks.”

We need to consider the negative implications of Yglesias’ desired policy of inflicting losses on small depositors for financial stability.  Yglesias simply assumes that his policy would improve bank safety by creating private market discipline that would return banking to “normalcy.”  Yglesias’ policy would create a strong incentive for small depositors in EU periphery banks to move their money to systemically dangerous institutions (SDIs) (the non-euphemism for “too-big-to-fail” banks), particularly U.S. and U.K. SDIs.  That general incentive will be compounded greatly whenever there is a report or a rumor that a Nation or a particular bank is troubled.   In the EU periphery, such reports or rumors are common.  These incentives can generate massive runs.  Not all runs are classic rapid runs.  Banks can lose billions of dollars in deposits over the course of months.  Bank runs are a regulatory and economic nightmare.

Yglesias is also far too confident about the benefits of requiring large depositors to suffer losses in the event of a bank failure.  He believes that this will create sophisticated private market discipline based on his assumption that large depositors “have the capacity to assess the soundness of different banks.”  This has never proven true.  There are studies that find that riskier banks pay higher interest rates on both insured and uninsured deposits, but that does not provide effective discipline.  Banks that are accounting control frauds typically pay higher deposit interest rates, but they are never closed by “sophisticated” depositors.  The broader truth is that no private sector institution has shown the ability to exercise effective private market discipline over fraudulent banksters.

All theoclassical finance theory predicts that subordinated debt holders will exercise the most effective private market discipline.  The theory is that their subordinated position means that they will frequently be wiped out if a bank fails, that only sophisticated creditors purchase sub debt, and that sub debt holders often buy such large amounts of bonds that it is highly worthwhile for them to bear the investigative expenses essential to effective private market discipline.  The reality is that sub debt holders have never effectively disciplined a fraudulent bank.  If sub debt holders consistently fail, then there is no reason to believe that uninsured depositors will succeed.  The record shows that they routinely fail to prevent “control fraud.” The reality is that private market discipline of financial control frauds is an oxymoron – the creditors fund the frauds rather than disciplining them.  The failure is easy to understand.  Banks that follow the fraud “recipe” experience a “sure thing” – they are mathematically guaranteed to report record profits in the near term (Akerlof & Romer 1993: “Looting: The Economic Underworld of Bankruptcy for Profit”).  Creditors break down the walls of the bank CFO’s office in their eagerness to lend to banks reporting record profits.

When Yglesias pines for the return of pre-2008 banking “normalcy” he betrays his devotion to theoclassical dogma and his inability to learn from the crisis.  The pre-2008 “normalcy” was one that even conservative finance scholars now concede was beset by “pervasive” control fraud at our “most reputable banks.”

Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market” by Tomasz Piskorski, et al. (February 2013)

“Normalcy” was faux private market discipline funding the rapid growth of fraudulently originated mortgages.  Those mortgages were then fraudulently sold to the secondary market where the fraudulent mortgages provided the faux backing to fraudulently sold toxic mortgage derivatives.  The frauds were so massive and grew so rapidly that they hyper-inflated the financial bubbles in many countries and drove the financial crisis and the Great Recession.  Yglesias promises that his policy proposals will return us to that criminogenic “normalcy.”

The only evidence of effective discipline against financial control frauds came during the 1980s and 1990s.  That discipline was exercised by federal S&L and banking regulators.

Yglesias’ take on Cyprus as of the morning of March 19, 2013

By Tuesday morning, Yglesias realized that the “well-organized” Cyprus plan was dead on arrival.

Yglesias’ plan to sell Cyprus to the Turks

By Tuesday afternoon, Yglesias had come up with his plan to save Cyprus by selling large portions of it to the Turks.  Yglesias called his plan the “Desperation Option.”

Here’s Yglesias’ explanation of his “too sensible” plan:  “here’s a plan that’s much too sensible to be considered – sell diplomatic recognition of Northern Cyprus’ secession to Turkey for the 5.8 billion euros that Cyprus needs.”  If we are very lucky, Slate will have no Cypriot readers.

What Yglesias’ proposal really proves is that Nations that give up their sovereign currencies give up a vital aspect of their sovereignty that can lead to humiliating losses of the most fundamental attribute of sovereignty – our Nation is not for sale at any price to anyone.

37 Responses to Yglesias Cheers a Double Betrayal of Cyprus

  1. Yglesias is an idiot. There is no consistency to his “thinking”, he writes in authoritative style about subjects with which he has only surface knowledge, and he misses the obvious – such as the rule of law and contracts that are dispensed with when wanted by our betters. He is a tool of whomever has his ear and punches his time card. What is puzzeling is that he has any readership at all.

  2. Fraud is based on deception. If the deception is successful, then obviously no market mechanism based on information can avoid or discipline a fraudulent actor until after his fraud collapses and he has made his escape. The same perpetrator won’t get away with it twice, of course, and that is the discipline that the market can bring to bear, what Adam Smith had in mind when discussing the local butcher. In today’s world, though, once is enough.

    The only solution, as is pointed out here, is government action. When the government is also corrupt, there is no hope.

  3. The current effort by the politicians of Cyprus to solve their economic problem indicates that the U.S. is not the only country that is not yet ready for self government.

  4. Yglesias is also far too confident about the benefits of requiring large depositors to suffer losses in the event of a bank failure. He believes that this will create sophisticated private market discipline based on his assumption that large depositors “have the capacity to assess the soundness of different banks.” This has never proven true.

    Yeah, this sounds like the Greenspan “model” in which he later admitted he had discovered a flaw.

    I was under the impression that the reason we did not have a general bank run in 2008 in the midst of the crisis is because of the ironclad FDIC guarantee system we created in the 30′s. I’m surprised Matt doesn’t appreciate that dimension of Eurozone stability.

  5. Isn’t that the beauty of punditry? You can be wrong, so long as you’re wrong with some amount of style. Most people forget. When you’re right, you look like a genius, even if it was purely accidental. What a great job to have…

  6. Bill:

    Do you still think lawyers get paid by the word? That ship sailed quite some time ago. How about posts that are half as long?

    • casino implosion

      The maniacal, hellhound-on-the-trail, all bases covered prolixity of Dr Black’s rhetorical style is part of why we love him. Yggy deserves this flogging, may god have mercy on his soul.

  7. Why doesn’t the European Central Bank just create more money and pay off the bond holders ? In other words, buy the bonds.

    • “Why doesn’t the European Central Bank just create more money and pay off the bond holders ? In other words, buy the bonds.”

      Moral hazard. A Resolution Trust Corp framework would be much more equitable, but as Bill pointed out recently, there aren’t many Seidmans on the horizon. :(

      • The ECB does not have to pay 100 pennies on the Euro for the bonds. It could just make a bid, just like any other commercial enterprise.

        Anyway, what is moral about 28% interest ?

        • Agreed, no moral hazard at a market rate, but that doesn’t resolve the banks failing. Capital injections are required. That’s how RTC worked. Save the banking system by ensuring orderly and equitable failures. (In other words, I’m not advocating a bailout for bondholders, sorry if it sounded that way.)

          Re 28%, this is a nitpick, but until debt is rolled over, those are just market yields, not interest rates in the sense of coupon payments, i.e., the banks and the govt are still paying the same coupons, but markets pay well below par to better reflect the associated risks. And the risks reflected in 28% yields are all about the EU and EMU’s poorly designed monetary system. So poor that it’s proving incredibly immoral.

  8. In general, the higher the rate of interest on a bond, the higher is the risk. Those people who buy bonds surely know this ? Caveat emptor.

  9. There is a simple solution to all this: it’s called “full reserve banking”. Under full reserve (at least as envisioned by Laurence Kotlikoff and Prof. Richard Werner), depositors have a choice between two options.

    First, they can elect to have their money kept in a 100% safe manner. And “100% safe” means 100% safe: the money is not loaned on or invested. It’s just lodged at the central bank where it may earn no interest.

    The second option is for depositors to have their money loaned on or invested. But in that case they have no moral right whatever to any sort of taxpayer funded guarantee or subsidy. Those making investments via the stock exchange get no taxpayer funded guarantee. Families who invest in a small business out of their own savings get no taxpayer funded guarantee. Why should those to make investments via a bank get any sort of guarantee?

    Laurence Kotlikoff teaches economics in Boston, USA. Richard Werner teaches economics in the UK. For details of his full reserve system, see:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    • Hi Ralph, a few random thoughts:

      Don’t savers already have this option (even if they don’t know it) in the form of checking accounts versus savings vehicles?

      Many ‘Austrians’ would love this proposal…but most of them are monetary cargo cultists (e.g., gold mines will provide ongoing optimum supply). Do you agree that a 100% reserve system would require larger sovereign deficits, all else equal? (I suspect the plan would lose most ‘Austrians’ there.)

      And without looking at the proposal (sorry, pressed for time), I suspect it doesn’t make any mention of this? I know Kotlikoff’s other work, he’s a smart guy, but utterly clueless re monetary operations and intra-sectoral balances, hence his application of intergenerational equity to sovereign budget deficits. Not sure I would trust him to design a financial system!

      Finally, AFAIK (I may be recalling incorrectly) Mosler supports uncapped deposit insurance?

      • I don’t think checking accounts have any more safety than savings accounts, except that the balance in the checking account may be less likely to exceed the FDIC maximum.

        If the bank is literally to store the money, and not lend it out, that would be more like a safe deposit box. You have to pay for that.

        Savings accounts without FDIC insurance is essentially what we had before the FDIC, with bank failures and bank runs a part of the landscape. How is that a superior solution?

        Repeal of Glass-Steagal was the critical mistake. Depositing your money in your local Bank and Trust Company is not the same as giving it to Goldman Sachs. They are in different industries, and ought to be separate enterprises, differently regulated. One should have FDIC insurance, the other not. One should be allowed to fail, if it makes poor decisions, no matter how big it is, the other not. One is a partner in a public-private banking system that operates in the public purpose, the other not.

    • They are proposing changes that would not work to imaginary system that does not exist. Pretty wicked.

    • If all money is created as debt, how can full reserve banking work ?

      No debts = no money.

      Therefore if all money were deposited in banks, there would be no more money to lend. In other words, when the bank makes a loan, its reserves would be depleted by that amount. How would the depositor get his money back in such a system ?

      Of course, the solution would be to have the government create and issue debt free money.

      http://www.govtrack.us/congress/bills/112/hr2990/text

      • Or the government could issue money, for instance when the Fed buys a T-bond.

        You can call it debt, I suppose, but it is between the Fed and the Treasury to work it out, meanwhile the private sector has more money, and the banks have more reserves to lend.

        And if the Fed never reduces its holdings of T-bonds, the depositors will be able to withdraw their deposits.

        I have no opinion about whether this is a good idea or not, but raising the required reserve ratio, even to 100%, is totally compatible with our current banking system.

        Even if you say that the Fed is not part of government, the system still works as long as the Fed acts like it is part of government, as it does today.

        • @golfer

          The Federal Reserve cannot buy US Treasury Bills directly from the US Treasury, it has to route the transaction via the private banks. Of the $16 trillion of US Treasury bills outstanding, the Federal Reserve now owns about $1.7 trillion worth. Half of the Treasury Bills are intergovernmental, which leaves around $8 trillion in private hands held 50% domestically and 50% offshore.

          It really does not matter whether you or I think that the Federal Reserve is a private or a public entity. The fact remains, though that 97% of the supply of US dollars is created by the private banks as debt. The US Treasury does not “create” the money it needs. It either has to borrow it, or receive it in taxation.

          The world is approximately $50 trillion in debt to the banks, which represents wealth to the few people who own the debt.

          http://www.economist.com/content/global_debt_clock

          • golfer1john

            I searched my reply, and I don’t see the word “directly”. Can you point it out?

            Even if Treasury borrows, the Fed “unborrows”. When the smoke clears, the private sector has $1.7T more than before, money which did not exist before, and the Fed has $1.7T of T-bills.

            That $1.7T that the private sector has can be borrowed and lent and withdrawn, regardless of the reserve requirement.

            • I was perhaps writing for a wider audience, when I mentioned that the Fed cannot buy Treasury securities directly. I did not intend to imply that you did not know. In fact I think one of your earlier comments put me wise to it. You make a good point that by holding Treasury debt the Fed “creates” money, but this does not let the Treasury off the hook. It still has to buy back the bills on maturity. Of course there is nothing to stop the Fed doing the same thing over and over ad infinitum. Maybe the Fed should buy all the US Treasury bills needed to fund government operations and reduce the need for taxation of lower income folk.

              I wonder how much money the Fed has issued worldwide. They stopped announcing the complete money supply figures sometime ago.
              http://en.wikipedia.org/wiki/Money_supply

              • golfer1john

                Yes, Treasury is “on the hook”, but as a monetary sovereign that is no burden for them.

                “Maybe the Fed should buy all the US Treasury bills needed to fund government operations and reduce the need for taxation of lower income folk.”

                You’ve got the causality a little backward. Lower taxation would increase the need (under our current laws) for the Fed to buy T-bills. Eventually. Plenty of excess reserves in the system to last a while. But, taken as a package, a good idea.

  10. –to put a “hideously unfair” plan to a vote in parliament is likely to lead to a rejection of the plan –

    Naturally this plan of charging interest on the deposits instead of giving some profit will not be acceptable to the account holders. An obvious result will be that there will capital flight to other countries. I do not see any germ of great idea by squeezing the depositors when they are convinced that their hardearned savings are being reduced instead of expanstion.

    • I’ve only seen references to “when the banks reopen”, but I think how it works is that the tax is levied on the deposits that were there last week, before the plan was announced, and the banks have been closed since then. Depositors cannot now avoid the tax by withdrawing their money, and since it is a “one-time” tax, there is no advantage to withdrawing it afterward. They might find it unacceptable, but they have no choice (short of revolution) but to accept it. They might withdraw their deposits from banks in countries that they think will be next on the list to do this.

  11. I don’t mean to be rude, because I enjoy reading a lot of your pieces, but I think you and some other writers of NEP tend to spend way too much rebutting someone whose ideas are trivial and patently unacademic. You’re compelled to take Yglesias seriously only by the virtue that he’s relevant to a handful of frothing, vicious, dimwitted commenters and occasionally cited by a few e-popular economists.

    There has to be legitimate debate for an esteemed economics professor that doesn’t involve picking on some barely recognizable, partisan ogre. You’re doing yourself a disservice. I think you should aim much higher, engage stronger intellects, and start taking on questions where the answer isn’t obvious, and your position might change by the end.

  12. Pingback: More on the debacle in Cyprus | Later On

  13. I also thought the Yglesias piece hardly worth the attention, though I find the Cyprus affair very alarming in
    a world of fractionally reserved, thinly capitalized banks and financial bureaucracies of dubious authority.
    No personal opinions to offer, but I thought some of you might find this Gary Gorton interview of 2010
    interesting as concerns financial system “confidence” in general. (He makes an analogy to our FDIC
    deposit insurance system in the paragraph titled “financial innovation.”) http://www.minneapolisfed.org/publications_paper>s/pub_display.cfm?id=4596

  14. My link doesn’t link, though it seems correct. The interview comes right up in a google search termed
    “gary gorton Minneapolis fed.”

  15. Actually, I think that taxing bank deposits is a great idea. There should be a progressive tax on deposits over $1 million starting at 10% working its way up to 90% at over $100 million.

    In this way inequality would be adressed and the economy restored to a better state of affairs. It is the concentration of money in too few hands, which has caused the real unemployment rate to reach 18% of the workforce and political corruption in the form of bribes that we euphemistically call campaign contributions. Wars for profit would become a thing of the past.

    • –I think that taxing bank deposits is a great idea–

      A disasstrous idea — result would be Banks will have to depend on the shareholders’ equity in the shape of ordinary shares and peferred shares etc.; fllight of capital from the concerned country; not much for lending that means a shock to investment and economic growth. Frank please think again!

      • It would have to be done on a worldwide basis in order to be effective. The first step would be the sequestering of deposits in tax haven countries. This could easily be done by hacking into their bank computers.

        This would render conventional warfare obsolete.

        • Still hoping your tongue is in your cheek, but how often would you impose this tax, and what makes you think there would be any accounts over $1M after the first time?

          • A wealth tax could be imposed worldwide on a yearly basis. Where would the oligarchs put their money, if not in banks ? I suppose they could buy gold or stock market shares, but these are also easily locatable.

            There really does need to be a more equitable sharing of the economic pie for humanity to develop beyond its predatory stage of development, because the current system is unsustainable. National progressive taxation is one method used for redistribution, but this does not work for money stashed offshore.

  16. golfer1john

    “A wealth tax could be imposed worldwide on a yearly basis. Where would the oligarchs put their money, if not in banks ?”

    Under the mattress? Fine art, uncut precious stones, jewelry? Charitable foundations that own their castles and provide them a “reasonable” stipend for managing it?

    • Now you know why the US upper classes are scared to death of communism. Their assets would have been confiscated.

      The English upper classes were also frightened of Russia in 1935 and this is why many of them sided with the Nazis
      including the Duke of Windsor.

    • Since only 3% of money is issued as cash, the oligarchs would have a hard time converting their bank accounts to cash. Charitable foundations are the way the super rich keep their money out of the IRS clutches. They make a tax free transfer of their assets to the foundation and then afterwards the foundation is required to donate just 10% of its PROFITS to charitable causes, which might in fact not be that charitable in the accepted sense of the word.