Despite the miniscule economy of Cyprus, events unfolding around its banking crisis will have broad and long-lasting effects far out of proportion to its size. When we say small, we mean really, really small. Cyprus’ GDP is less than half that of Rochester, NY or Des Moines, IA, or about the same size as Winston-Salem, NC, and less than 0.2% of the EU economy.
But the significance of last weekend’s ill-conceived decision by the European summit to require confiscation of depositor funds in Cyprus banks has triggered uncertainty in European markets and generated a backlash in Cyprus and beyond. Depositors ran on ATMs, Russia’s Putin has protested the confiscation of the deposits of Russian depositors, and the streets of Cyprus are filled with protesting consumers. While these are short-term consequences, the longer-term ramifications are far more significant. In the midst of a fiscal and financial crisis that is still evolving, politicians have called into question the efficacy of deposit-insurance commitments to depositors throughout Europe.
They have learned no lessons from US experiments with state-sponsored deposit insurance funds. Every one of these has failed, including funds in Mississippi (1976), Nebraska and California (1983), Ohio and Maryland (1985), Utah and Colorado (1987), and Rhode Island (1991). The funds all failed due to problems that currently plague European banks. These include net-worth deficiencies in member institutions, lax supervision, and inadequate resources in the deposit insurance funds and/or reluctance of state legislatures to impose losses on taxpayers to make up the deficiencies in funding of the insurance guarantees. In almost all cases in the US, the knock-on effects of the fund failures on healthy institutions were remedied by replacing state-sponsored funds with federal deposit insurance.
The parallels between the US experience and what we are seeing in Europe are eye-opening. In Europe, there are many sovereign-sponsored deposit insurance funds that vary greatly in structure and funding. All suffer because they lack sufficient resources to deal with insolvent institutions, and in most countries their insolvency regimens do not equip them to handle banking failures in a prompt and fair manner. To make matters worse, there is no scheme similar to our FDIC to step in when a country such as Cyprus cannot meet its commitments. Nor is there willingness, this time, on the part of others with the resources – i.e. Germany – to shoulder the financial bailout that is necessary. In the present case, evidence suggests that part of the German reluctance to share the burden is financial and part is political, in that German politicians are unwilling to support transferring funds to Russian oligarch depositors in Cypriot banks.
European leaders have now recognized their mistakes and are scrambling for alternatives. In Cyprus, the public outcry means that the government lacks the support to proceed on the terms proposed by the European summit. How the Cypriot government will respond has not yet evolved, and in the meantime the banks are closed.
But regardless of what happens, the consequences will be lose-lose for the EU and its banking system. What the politicians have done is to call into question the value of depositor guarantees throughout Europe, since depositors both large and small have no certainty that the commitments made will be honored in a time of crisis, regardless of the size of accounts involved. The immediate implications for depositors in Portugal, Spain, Italy, and Greece are also clear. Their funds are now at risk, regardless of what their governments or EU ministers say. Claims by politicians that Cyprus is a unique event will fall on the deaf ears of rational depositors. The damage has already been done.
For the US and US banking institutions, this is good news in that US banks will experience inflows of large deposits, since these are the funds most at risk to government confiscation. As a result, the dollar should appreciate, at least temporarily. Of course, a stronger dollar will hurt US exports to some degree. Much has already been written about the implications for Swiss banks, and speculation is widespread about negative interest rates in Switzerland.
Finally, there is a big lesson here for our own politicians, who have failed to deal with our fiscal deficit. The endgame of continuing deficits and a growing federal debt burden is clear, the protestations of Alan Blinder and Paul Krugman notwithstanding. We are headed down the path already followed by Europe if we don’t lower limits on the size of government expenditures as a percent of GDP and match those expenditures with appropriate revenues.