Asymmetrical Information - Megan McArdle

03.22.13

Cyprus is Imploding, So Why Aren't Markets Freaking Out?

The failure to reach a deal is a BFD. But so far, markets yawn.

The single biggest fact you need to know about Cyprus is summed up by Kevin Drum's admirably pithy headline: Cyprus needs to lay its hands on one-third of its GDP by Monday.  Otherwise, the island nation's banks are insolvent--and since a surprisingly large fraction of its economy seems to consist of selling bank accounts to Russians, that presents something of a conundrum.

I'm still trying to wrap my brain around how we arrived at this impasse. It seems as if at every turn, the governments involved have actively, even joyously, bounded towards the worst possible decision.

To be sure, it isn't as if there were a lot of great decisions available to be made.  There's a big hole in their banking sector, and no obvious way to plug it without a huge cash infusion RIGHT NOW--which doesn't leave a whole lot of alternatives to taxing the bank accounts, or getting a big bailoit from the EU.  And the EU is getting kind of sick of bailouts.

Still, it's hard to understand why the Germans apparently insisted that the Cypriot governmetn kick in so much money that it was left with no alternative to slapping a tax on its bank deposits.  Yes, I do understand that the Germans didn't want the Spanish and Italians and Irish and Portuguese thinking that a similar deal might be forthcoming if they let everything go to hell.  On the other hand, if their depositors get worried about similar haircuts . . . well, it's hard to say that they'll be in a better position.  And what if they succeed?  Cyprus slaps a hefty tax on its bank deposits, and then five gets you ten that they have a bank run which sows considerable chaos throughout the EU.

On the other hand, once they'd insisted, it's hard to see why a rational parliament wouldn't accept the deal.  Angrily, fearfully, more-in-anger-than-in-sorrow, yes.  But unless they think that the GDP fairy is going to drop off enough cash to make their banks solvent by next week, this doesn't make any sense.  Yes, if they tax the bank deposits, they will cost small savers some money, and risk triggering an even bigger crisis when anxious russians decide to take their depsoits elsewhere.  Yet, this is exactly what will happen if they don't take the deal: the banks will be insolvent, the Russian accounts will flee, and the small depositors will lose far more than the 3% or 7% or whatever percent that taking the EU deal would haverequired them to give up.  So aside from a stirring expression of national pride in the face of a stupid and shortsighted German ultimatum, I'm hard-pressed to see what is accomplished by having the Cypriot cavalry charge straight into the maw of the oncoming tanks.  

Of course, political systems thrive on stirring and shortsighted expressions of national pride.  This is not the first time we've seen such displays during a financial crisis, and it certainly won't be the last.  Which actually raises an important question: why aren't markets freaking out?  There are alll sorts of scary lessons to be taken from the Cypriot experience, starting with: the eurozone may well decide that your bank account should be decimated pour encourager les autres.  If Cyprus decides to leave the euro--and if it refuses the EU deal and lets its banking system go, it will pretty much have no choice--the lessons get even scarier.  But so far, the markets have pretty much offered a big yawn.  

What are the explanations for this? The first is obvious: Cyprus really is unique.  It's a tiny island nation with a big, big banking system, and so far, it has essentially told the eurocrats to go jump in the lake.  Perhaps they reckon that odds of this being repeated are not huge.

The second is almost as obvious: they just don't believe that when push comes to shove, the eurocrats and the Cypriot parliament are going to agree to let Cyprus go over the ledge.

Then we get into more exotic territory, such as this offering from Steven Lewis at Monument Securities, via the FT:

More likely, investors realise the ‘knock-on’ effects from a Cypriot default are literally incalculable. But they are insensitive to bad news. They respond to those factors which would lead them to buy financial assets; they can do nothing with any other information. Central banks’ massive asset purchases have set up a situation where the markets’ normal signalling mechanisms no longer operate because investors have huge volumes of uncovenanted liquidity, created by the central banks, to commit to long-term assets. The central banks would, no doubt, claim this as a triumph for their asset-buying policies. They do not want to see economic recovery blown off course by recurrent financial crises. However, for those who believe free markets are the most efficient means of allocating capital, the impairment of the capital markets’ pricing function must be cause for concern. It presages serious misallocation of capital, carrying negative implications for future economic capacity. The most extreme and obvious form of misallocation is seen when a market ‘bubble’ forms. The bursting of a bubble may have spectacular consequences. But misallocation of capital may occur even when a ‘bubble’ does not form. For example, when investors, in their quest for yield, overlook significant differences in the risk-adjusted returns that assets may realistically be expected to provide. Central bankers say they are on the look-out for ‘bubbles’ but they seem unconcerned about any broader misallocation of resources their policies may generate.

Relatedly, the WSJ offers this explanation from David Bloom at HSBC: "People just don't know how to trade this stuff"

In other words, the crisis is coming.  But we have to have the crisis to find out what's in it.