When I first wrote about the Eurozone crisis, almost two years ago, I noted that besides the GIIPS, Belgium and Cyprus were prime candidates for a serious banking crisis. And it looks like, the events that unfolded last week finally heralded that day of reckoning.
I am not going to write extensively about the financial details of the problem, as it is covered in some detail in most media outlets. I just want to make a couple of points.
From where I stand, the Cyprus crisis is a strong indication that the Eurozone is no longer a viable arrangement. I am not suggesting that the EU and the Euro will cease to exist. They won't. At least not in the short to medium run. But I believe that one way or another the Euro itself and the area around it will have to be restructured, shedding perhaps a few members in the process.
This not idle speculation on my part as there are a few fundamental reasons for that.
Is Euro a Unified Currency?
We all know that it is not. A while ago, I explained why it wasn't by using the trade and exchange mechanisms within the EU.
Without going into all of that, let me make the same point this way: A unified currency, like the dollar, has the same purchasing power within its territory and yields the same interest rate regardless of its location. When you borrow in New York you pay the same interest rate for it as when you borrow in Oklahoma.
The Euro, on the other hand, has a different valuation depending on its location. For instance, in Germany, the Euro is lent at 2.8% but it Portugal the same loan will cost your company 6.7%.
Why is that important?
For one thing, it means that even of you could bailout banks in GIIPS (and Cyprus) and supply them with fresh liquidity, that money will not stay there but will end up in German banks. Or to put it differently, if I had a billion euros and decided to make a deposit in a Greek bank hoping that they would lend this money locally and stimulate the economy, I would fail miserably. Because the rational course of action for the bank would be either to move my money to safety in German banks or to lend it locally with an exorbitant risk premium on it.
So much for stimulus.
The Euro cannot survive such regional disparities for a prolonged period of time. On top of that simple capital flight and cost differential, there is the issue of the conflicting economic targets between the center and periphery. As Krugman has been saying for some time now, implementing austerity to keep Germany's inflation targets will mean deep deflation in GIIPS (and Cyprus). You ever took Economics 101, you might remember that deep deflation equals collapsing prices, contracting economies and, of course, high unemployment.
Just yesterday, it was announced that the Eurozone unemployment rate has reached %12.
This is simply untenable, either economically or politically. Sooner or later, something will break.
What Are the Troika and Germany Doing?
Besides the structural problems associated with the Euro, there are also serious issues created by the peculiar policies of the Troika (i.e. the EU, the ECB and the IMF), Northern creditor countries like Germany and the banks.
Let's quickly recap the measures they have been implementing to deal with the crisis.
As you will remember, when the real estate bubble burst in 2008, Iceland was first to collapse. Its banks were given way too much money by the usual suspects and they simply went bankrupt under the weight of their excessive debt. Banks and the creditor nations put the squeeze on Iceland to guarantee those loans. Iceland did not budge. They said, sorry mate, you knew the risks when you made the loans, that's capitalism, you win some, you lose some.
At the time, there were dark predictions about Iceland becoming an outcast in the international financial circles. None of it came true. Within a couple of years, Iceland was back on its feet and was borrowing money on very good terms.
In the same time frame, Ireland was faced with the same situation: Too much money channeled into their banks by the same institutions and not enough real estate demand to make those loans profitable. In that case, the usual suspects convinced Ireland to nationalize the private debt of its banks. Banksters, who, until then, were praying to get half of their money, realized that with a little bit of trickery they could be made whole again. As a result, unlike Iceland's, the Irish economy was ruined and there is still no end in sight.
The Irish case was important because it effectively took the element of risk out of the banking game. You make risky loans, charge risk premium for them and if something goes wrong, you scream bloody murder and they take money from the poor and pay you back.
That was really lovely.
The third case was Greece. The first leg of the bailout plan, as conceived by the Troika and its assorted allies, consisted of engaging in a prolonged PR campaign to vilify Greeks as lazy and useless cheaters. We were presented all kinds of anecdotal evidence that Greeks were just greedy losers who grabbed money like there was no tomorrow. Thanks to that barrage of negative stereotyping, no one asked the obvious questions: How could a few politicians' largess account for a national debt that reached 160% of GDP? Or how could the banksters continue to shovel money into Greek economy while simultaneously teaching its government ways to hide this excessive level of debt? Or how could the EU be unaware of Greece's extraordinary indebtedness given the huge sums involved?
Once that narrative was in place, no European taxpayer would agree to bailing out such lazy bums. That made the proposed solution (imposing austerity measures) very palatable despite its huge social cost: Forced austerity meant that the Greek economy would keep shrinking for the foreseeable future; its population would become increasingly more unemployed and impoverished and yet despite all this suffering, its debt to GDP ratio would remain more or less the same or possibly become worse.
No one wondered how and why this was a good idea. Everyone felt warm and fuzzy that those cheaters finally got what they deserved.
Then they turned to Spain and Portugal. My post entitled "Can Anyone Tell Me What Is Wrong With Spain?" highlighted the inherent contradictions between the mainstream narrative and the local economic realities. Of nearly 200 hundred posts I did in over two years, this one got the most clicks. The numbers I offered seemed to indicate that the Northern creditor groups forced Spain into a recession and a high unemployment situation despite its diversified and comparatively healthy economy.
Then it was Italy's turn. For a few months, the business pages of mainstream papers were full of "contagion" theories, telling us how Italy's imminent collapse was going to bring down the Euro and the European project. The narrative became so strident, so urgent and so convincing that eventually the Italian MPs forced Prime Minister Berlusconi to resign. Then they replaced him with an unelected politician: a former EU Commissioner and an advisor to Goldman Sachs.
Regarding Monti and his evidently successful reign, consider this. Can you enumerate any of his specific policies that averted the imminent collapse of the Italian economy? Me neither. That's because he did not do much. Sure, he tried to push through some reforms. But when they were met with resistance, in a time-honored Italian fashion, he watered them down. Tellingly, in his BBC profile his main achievement was listed as calming the markets. But the piece is silent about why the markets grew calmer under him and more importantly, why the same steps could not have been taken by Berlusconi.
At the beginning of the 2008 crisis, Cyprus was doing very well. Their debt to GDP ratio was under 50%, which was much better than Germany's or most of the Eurozone countries'. Their unemployment was hovering around 4%, also exceptionally low for Europe. And they had a steadily growing economy since 1974.
Their problem was the same as Ireland, Iceland, Spain and a host of other countries who were given too much money. Early on, Cyprus had partly copied the Irish formula by offering a very low corporate tax rate (10% and as far as I know, the lowest among EU countries) to attract foreign companies. They also tried to become an offshore financial haven. They signed a deal with Russia in 1982 which made possible for Russian companies to move their profits to offshore accounts by passing them through Cyprus without paying taxes.
The banking infrastructure that was built to accommodate these transactions got the attention of the usual suspects. They shoveled money into these relatively inexperienced Cypriot banks, increasing their assets to €152 billion or 8 times the island's GDP. When you manage such large assets and have to show returns, you do what the Irish, Spanish or American bankers did, invest them in the booming real estate market and its highly risky assets. In Cyprus' case the island's economy was too small, so they invested much of it in Greece.
Then Greek real estate market tanked and Greek banks went bust. The exposure of Cypriot banks to Greek debt was roughly €30 billion or 1.6 times the island's GDP.
Here is where it gets interesting. If you followed the Greek debacle you might remember that the so-called "haircut" process was spread over two years. In the beginning, Merkel, the French and German banks and ECB's Trichet were adamant that no haircut was acceptable for senior debt holders. During that process, Bank of Cyprus and Laiki Bank began buying Greek debt in huge quantities from, you guessed it, Deutsche Bank. It was a gamble. But they figured that Germany would never allow a huge haircut and the yield on Greek bonds were huge at the time.
Between the two of them, they gobbled up another €6 billion of Greek debt. Right after that, Germany made an about face and a 75% haircut was announced. Once they wrote this off, these two banks had no money left to operate and they had to approach the government for a bailout.
Since the government had already hit its borrowing limit, they in turn had to approach the ECB. The Troika took over and said that they are willing to give Cyprus 10 billion euros if Cyprus could raise 6 billion euros by itself.
Where do you get such funds if you have no ability to borrow money? The Finance Minister asked if Russia would buy some offshore oil and gas bonds from Cyprus. Russians said no, thank you. The offshore oil and gas deposits came with a long standing territorial dispute with Turkey and Russia did not want to antagonize its rising neighbor just as Syria was about to go up in flames.
The Troika then suggested that the government should tax all accounts in Cypriot banks. They proposed a 6% levy on savings below €100,000 and 10 % above that amount. The wink-wink, nudge-nudge gesture behind the suggestion was that most of that money belonged to Russian oligarchs anyway and they would or should not care.
That did not go over very well. So, the final plan was to leave the deposit of €100,000 and less alone and confiscate up to 60% of larger deposits (actually they plan to turn them into shares in local banks).
Of all the strange policies the Troika implemented since the beginning of the banking crisis in Europe this is the most peculiar.
Think about it.
- It is estimated that the island's GDP will shrink by about 20 % in the short term. No matter how you slice it, this will be catastrophic for ordinary people. And I don't see how the Cypriot economy can recover from this.
- I seriously doubt that the Russian oligarchs had much money in Cyprus (if I knew about it two years ago, surely their advisers would have known much earlier that that). But whoever these Russian deposit holders are, it is safe to assume that they are closer to Kremlin (as this is the norm to operate in Russia these days). Why is it a good idea to piss these people (and Kremlin) off? Does Europe need more confrontations with Gasprom?
- Next year, Latvia will join the Eurozone. They too have large deposits from Russian companies. Will these account holders stay in Latvia on the basis of this precedent? If not how will that affect Latvia's economy?
The Future of EU
Perhaps the most important consequences of the Cyprus "solution" could be the realization that the Troika is not trying to find solution for local economies. People might look at the overall picture and discover that the EU and the ECB have not been acting to save local economies or bailout local banks: they have been trying to protect the senior debt holders (banksters) and creditor nations.
Worse, in some cases, they have been forcing entire economies into prolonged recessions.
The European project and all the talk about solidarity and unity and economic and political integration could become a wry joke for the people at the periphery as they continue to suffer under crippling austerity measures with no end in sight.
Moreover, whenever you have large segments of the population (and especially the middle classes) decimated for long periods of time, you create a very volatile situation that encourages extremist political formations. The rise of Golden Dawn is the most prominent example of that scenario. But other European countries are affected as well.
In Spain, Espana2000 is openly emulating Golden Dawn and is growing steadily. Le Pen's Front National in France is already very popular and it could become the largest right wing party during the next presidential elections in France. In Italy, Northern League, a party called fascist-lite, was part of Berlusconi's coalition and has been gaining more electoral support every cycle. The same is also true for National Alliance. In Portugal and Eastern Europe, anti-immigration parties are on the rise and their positions that could once be labeled center-right are not solidifying into extreme right platforms.
Unless there is a major shift soon, we may one day look at this relatively insignificant bailout process in Cyprus and say that, although we did not realize it at the time, it was indeed the beginning of the end for the European project.