Why the Logical Response to a Financial Crisis Almost Never Happens
Forget the technocratic analysis. Is it politically palatable?
Is this how the euro ends? Not with a Greek bang, but a Cypriot whimper?
The Cypriot parliament has rejected the proposal to recapitalize their banks using a combination of international funds, and the proceeds of a special "tax" on bank deposits. EU ministers are said to be discussing capital controls.
In these sorts of situations, capital controls are often imposed prefatory to abandoning your currency peg and "recapitalizing" your banks by redenominating their loans in cheaper local currency. This does not have to be the case ,of course. Even if Cyprus isn't planning to leave the union, they face a big problem: given all the problems in the banking system, a euro-denominated bank account in Germany has a higher expected value than a euro-denominated bank account in Cyprus. The money will probably flow accordingly, undermining the stability of the banks still further. Even if they're 100% committed to staying in the euro, they will probably face sizeable outflows when the banks reopen.
Nonetheless, capital controls are often a prelude to a devaluation, and given the size of the problems in the Cypriot banking system, this seems like a real possibility.
This would not, I must point out, be good for Cypriot savers, who are likely to lose more than 6.75% of the value of their bank accounts if Cyprus exits the euro and returns to the Cypriot lira.
Nor would it be good for Germany and the other core eurozone nations. If Cyprus exits the euro over a demand for bank depositors to take haircuts, there's a good chance that one of two things will happen: Greek and Spanish and Irish depositors will start meditating on the fact that a bank account in Germany is equivalent in value to a bank account in their home country--and more valuable if they exit the euro. Or investors in Greek and Spanish and Irish bonds will get a good glimpse of what a euro exit actually looks like--and decide they'd rather put their money somewhere else. Either way is probably the beginning of the end for the euro as we know it.
A euro exit may be the only stable, workable option in the long run. But in the short run, it will be disastrous for everyone involved. So it's perhaps a bit surprising that both sides have insisted on doing things that were obviously unhelpful: the eurocrats by insisting that depositors take a haircut, the Cypriot parliament by turning down a bad deal that was nonetheless better than no deal.
And yet, I no longer find these things surprising. Ten years ago, watching Argentina implode, I used to spend a lot of time asking analysts and other financial journalists why they couldn't do the obviously necessary things to stabilize their economy and maintain access to world markets. Ten years later, as Argentina continues to actively maintain its pariah status with unnecessarily aggressive negotiating tactics, this seems entirely normal. The technocratically obvious solution is rarely politically possible, except maybe in a few tiny and very homogenous countries in Northern Europe.
(Corollary: the creation of the EU has collectively worsened the quality of European technocratic management. Discuss. Please use at least three countries as examples and address the role of both the European Parliament and the European Central Bank. There will be a 20 point bonus for analyzing the failure of the Lisbon Agenda in this context.)
The German politicians who allegedly insisted on taxing depositors may have thought that they could make Russian oligarchs fund their bailout without triggering serious financial repercussions. Or they may just have though that they needed "stiff penalties" to sell another bailout to their voters. Are Germans really supposed to cough up more money to bail out banks that offered a tax haven to a bunch of crooked Russians, while Cypriot depositors are made whole?
The Cypriot parliament may have thought they were giving the government more leverage to get a better deal. Or they may have thought that giving depositors a haircut in order to keep Russian money from fleeing the banks was likely to bring down their government. And in that latter supposition, they may have been right; they certainly know more about Cypriot politics than I do. Are Cypriot small depositors really supposed to lose their hard earned life savings--which they were promised had deposit insurance!--because a bunch of German politicians demanded it?
For that matter, maybe markets really will shrug off whatever happens in Cyprus as sui generis, with no larger implcations for the rest of the euro. They certainly don't seem too worried today.
Nonetheless, the fact remains that these votes were, from a technocratic perspective, very risky. The Germans are risking a bailout of the PIIGS that will cost far more than the piddling $5 billion it would have cost to recapitalize Cypriot banks. And the Cypriot parliament is risking a financial crisis and bank collapse that will be far, far worse than a 6.75% bank levy. They did these things because they felt they had to in order to face the voters.
Which is a helpful reminder that responses to a crisis don't just have to be macroeconomically stable; they also have to be politically stable. It's still far from clear that the "logical" solutions to the eurozone crisis have enough political logic to sustain themselves in the face of the parochial and moralistic instincts of the voters.