Liquidity vs. Stupidity: Two Early Lessons from Cyprus

March 22nd, 2013 at 8:25 pm

If Chairman Mao said, after two centuries, that it was still too soon to judge the impact of the French revolution, it’s probably a bit premature to learn much from the ongoing Cyprus bank debacle.  That said, we at OTE are obliged to briefly speculate:

#1: OK, I’m gonna go out on a limb on this one, and assure you that we don’t need a lot of time to transpire to learn this lesson: unless you’re trying to start a bank run, don’t spring a tax on bank depositors.  As I’ve always stressed, the problems in the Eurozone are deep and not amenable to simple solutions, so I’m willing to be told I’m missing something important.  But didn’t someone around the table in Brussels raise their hand and say, “hey, wait a sec…do we really want to levy this tax on a banking system that’s already teetering?”

#2: The above is obvious.  This one, less so, but it’s a lot more important: Large imbalances often lead to underpriced risk, over-leverage, and systems’ failure (default, near-default, long recessions with over-corrections (Minsky moments)).  The Cypriot case looks like one where a lot of offshore money, some allegedly hot from Russia, found its way to a tiny nation selling international banking services.  Some reports suggest the banking sector grew to seven times GDP, though Yves Smith tells a more nuanced story with convincing data here.  But the lesson still holds.

Banks, commercial or otherwise (I-banks, S&Ls, mortgage lenders), don’t make money by sitting on it.  They must lend.  And when they’re experiencing large inflows, whether from Asian investors in the US housing boom or Russian gangstas, they go shopping for places to amplify those flows.

That’s finance—there’s nothing wrong with it (except maybe the gangsta part).  To the contrary, the text book case is that these excess savings find their way to the most productive uses and the virtuous cycle is off and running.  But the real world case looks a lot different.

In the US and some parts of European meltdown, sloppy underwriting and “innovative” finance plowed the excesses into a massive housing bubble that lost trillions and from which we’re only now recovering (while much of Europe remains mired).  Greece over-leveraged on imbalanced surpluses from northern Europe with no fiscal structures in place to finance its debts, and Cyprus invested in Greece.

Again, I’m grossly simplifying and more time must pass before these autopsies reveal their real lessons, but I suspect once they do they will show the following: capitalism in this era ran amok in no small part because policy makers accepted the teachings of the high-priests of economics that modern economies self correct. They work out their excesses and imbalances without state intervention, oversight, or regulation.  Those functions, the priests said, would only cuff the free hand.

I’d like to think that we now know that the free hand, uncuffed, is often all thumbs.  I’d like to think that our policy makers are interested in systems that identify the types of destabilizing imbalances from which we’ve suffered in recent years.  That’s what I’d like.  I doubt it’s what I’ll get.

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6 comments in reply to "Liquidity vs. Stupidity: Two Early Lessons from Cyprus"

  1. Vadranor says:

    I think you meant to attribute the comment to Premier Zhou Enlai, not Chairman Mao.

  2. Max Maximus says:

    Sorry, Jared, it was Zhou Enlai not Mao who made that famous remark on the French Revolution.

  3. Procopius says:

    For goodness sake, are you really that young? It wasn’t Chairman Mao who said that, it was Chou En-Lai, the Foreign Minister, delegate to the Paris Peace Talks, truly urbane intellectual, and probably the only one of the original Chinese Communist Party leaders whom I can really admire (Mao was a great strategist and political leader, but he was also pretty corrupt and kind of dumb).

  4. paul w. says:

    Just to be a pedant …

    a) it was Chou, not Mao
    b) He or his interpreter misunderstood the question to be about the student uprising in Paris 4 years earlier.

    Yet another great anecdote bites the dust.

    3) On another note, Kevin Drum speculated yesterday that the Germans (or maybe the Eurocrats) see Cyprus as an inexpensive example for the southern PIGS about the cost of leaving the Euro. Interesting idea.

  5. Brock Haussamen says:

    Very helpful post. Thanks. Also, you treat the Russian gangsta money with a light touch. I don’t know if illicit money from developing countries in Africa also found its way to Cyprus, but if so, that’s not so light. That siphoning–both from gangstas and legit businesses dodging taxes–is a major reason parts of Africa are so slow to move ahead.