03/25/2013 01:17 PM

Lessons from Cyprus : Euro Crisis Poses Grave Dangers to EU Unity
Cyprus was forced to sacrifice its position as a financial center in exchange...
Cyprus has been saved. But the euro zone may ultimately be the biggest loser. The tough negotiations clearly demonstrated that Europe's north and south no longer understand each other -- and the political differences could soon become more dangerous than the currency crisis. By SPIEGEL Staff

It has been only four weeks since German Chancellor Angela Merkel had nothing but nice things to say about her "very esteemed" counterpart in Cyprus. In a telegram to newly elected President Nicos Anastasiades, she "warmly" congratulated him on his election victory and wrote that she looked forward to their "close and trusting cooperation."

That was then, as Merkel conceded last Friday in a speech to the parliamentary group of her center-right Christian Democratic Union (CDU) at the Reichstag in Berlin. Although her intent was not to set an example, she said, Germany also would not "give in." She added that there would be "no special treatment" for Cyprus. And over the weekend, she lived up to her word.

The island republic in the eastern Mediterranean is about as economically significant as the German city-state of Bremen, and yet the attention of citizens and politicians alike was focused on the debt-ridden country on the continent's periphery last week and through the weekend. Since Cypriot parliament rejected the initial bailout plan, one crisis meeting followed the next in Berlin, Frankfurt and Brussels as concepts were presented, revised, rejected and resubmitted. In the end, the European Central Bank (ECB) imposed an ultimatum on the country. The message from ECB President Mario Draghi was that either Cyprus agree to the bailout conditions or it could be the first member of the euro zone to declare a national bankruptcy.

In the end, Nicosia agreed. The country's oversized banking industry is to be radically downscaled, one of its biggest banks, Laiki, is going to be dissolved and those holding accounts there will see volumes over the €100,000 insured limit potentially vanish. A worsening economy will almost certainly be the result. The deal came just a day before the ECB ultimatum -- a cessation of emergency liquidity for the country's banks -- was set to become reality, a move that would have resulted in a messy crash of the country's financial system.

Graphic: Cypriot debt and financing needs.

Smoldering and Flaring

Despite the deal, Cyprus was making preparations for the reopening of banks this week. Financial institutions there have reportedly hired extra security in preparation for an onslaught of furious customers. For the last several days, they experienced what it's like for a country to literally run out of money. Many service stations only accepted cash, and some kiosk owners closed up shop when they ran out of cash to make change. Bank machines over the weekend were only giving out €100 per day, per customer.

Smoldering and flaring for the last three years, the euro crisis has reached a new stage. For the first time, a parliament rebelled against the requirements of international creditors, and for the first time euro-zone taskmasters tried to take a slice of the savings of ordinary citizens, prompting people throughout the continent to wonder whether their money is still safe. The unprecedented showdown led many in Europe to speculate over the national character of the Cypriots, and wonder: Are they especially jaded, desperate or simply nuts?

Finding the right answer was the perplexing task for leaders in Brussels, Paris and Berlin. How far can one bend to demands from a teetering country like Cyprus without losing one's credibility? At what point does a debt-ridden country endanger the entire financial system, and how can allowing it to go bankrupt still be the right approach? Finally, how does one rescue a country that doesn't want to be rescued?

It was a matter of risk and confidence, of European solidarity and of Merkel's crisis management. In recent months, the chancellor seemed to have stopped the impending collapse of the common currency with her recipe of aid in return for reforms. Investors had calmed down, capital was flowing back into Southern European economies and in recent weeks German Finance Minister Wolfgang Schäuble (CDU) seemed as relaxed as the markets.

But a monetary union, at its core, is not held together by budget figures or austerity programs, nor by the statements of finance ministers and the heads of central banks, no matter how well-received they are in the markets. The most important glue holding together a monetary union is the mutual confidence of its members, and that has declined drastically in recent months. While many in the north question the willingness of politicians in Rome and Athens to bring about reform, citizens in the south are increasingly furious over the austerity diktats from Berlin, Brussels and Frankfurt.

Different Planets

There are predetermined breaking points all across the continent, but they are more apparent in Cyprus than anyplace else. Lawmakers in Berlin see the small country as a haven for the illegal money of wealthy Russians that urgently needs to be shut down. In contrast, island residents see themselves as the innocent victims of a ruthless bailout policy. Cypriots and other Europeans spent nine months in Brussels hammering out a solution to the crisis, but all the while it seemed as if they were living on different planets.

Seen in this light, the debacle over the debt-ridden island nation is more than just another financial crisis along Europe's southeastern edge. It is emblematic of the entire monetary union. If the euro zone collapses, it will be because of both its economic contradictions and its members' inability to reach agreement. Last week, European politicians involved in the bailout were calling Cyprus a "special case." And perhaps it is. But there was a very real danger that the crisis on the island could have ultimately become the straw that broke the euro's back -- a back which is still fragile indeed.

Depending, of course, on whom you listen to. Klaus Regling, head of the euro bailout fund European Stability Mechanism (ESM), has been giving presentations around the globe for months. Last Monday, he stood on a small stage at the Friedrich Ebert Foundation in Berlin, exuding indefatigable optimism. The euro zone is on a difficult path, Regling admitted, but "relevant data shows that the strategy is working."

Those in the audience were shaking their heads in disbelief, but the 62-year-old allowed the facts to speak for themselves. His slides showed colorful graphs indicating how much debt-ridden euro-zone member states had cut spending in recent years. Both Italy and Spain have packages of cuts and tax increases worth dozens of billions of euros in recent years.

Long-Overdue Reforms

Thanks to an aggressive consolidation strategy, many of the hardest hit countries have managed to drastically reduce their budget deficits. Greece, for example, has managed to reduce its deficit by almost 10 percentage points relative to gross domestic product within three years, a record among the world's developed countries. Were Germany to have done the same, some €250 billion in federal, state and municipal spending would have had to have been cut.

In addition to the austerity measures, governments across the Continent have tackled long-overdue reforms. Portugal eased access to previously protected professions and eliminated some holidays and vacation days. Spain relaxed protections against employee termination. In Greece, the government reduced the minimum wage by almost a quarter, and by a third for younger workers. The government in Rome raised the retirement age.

Even more importantly, these policies produced the desired results. Throughout Southern Europe, citizens have purchased fewer imported goods and exports have risen. Current account deficits in Southern European countries have declined to just a few percent of their GDPs. These countries are even exporting more goods now than they were before the crisis began.

"To be honest, I sometimes don't understand why this progress is often not noticed in Germany," says Regling.

The problem is that while Europe has become more economically harmonized, it is drifting apart politically. The reforms have made the southern part of the continent more competitive, but people are not necessarily benefiting from these economic successes. On the contrary, unemployment remains at record high levels, and poverty is on the rise. At the most recent EU summit, outgoing Italian Prime Minister Mario Monti spoke of a "time lag."

Monti knows what he's talking about. After all, that time lag explains why he was unceremoniously voted out of office a month ago. Monti claims that, even though he explained his policies at length, anti-European forces won the Italian elections.

Yet people are turning away from Europe in almost all countries that have suffered economic upheaval recently. Anti-austerity protests are increasing again in Greece, even though the government hasn't even implemented certain reforms yet. Social conflict is likewise on the increase in Spain, where half of all young people are now unemployed and the government of Prime Minister Mariano Rajoy is under fire because of a corruption scandal. In France, President François Hollande has seen his popularity drop to a new low -- to the point that he has been overtaken in the polls by Marine Le Pen, head of the far-right National Front.

Deep-Seated Mistrust across Euro Zone

The anti-European mood in the south, in turn, has spurned the euro-skeptics in the north. Many Germans, Finns and Dutch long felt that Mediterranean countries were incapable of economic reform. As proof, they can now point to Italy's election winners, Beppe Grillo and Silvio Berlusconi, both of whom are publicly contemplating a withdrawal from the common currency.

There is deep-seated mistrust in all of Europe, but the suspicions run particularly deep between the Germans and the Cypriots. For months, the euro-zone leaders sought a solution for the debt-ridden country, but in the end the country still lacked €5.8 billion of the €7 billion it was supposed to contribute to its own bailout.

One of the primary hurdles is the Cypriot conviction that they are more victims of the crisis than they are perpetrators. After all, the main reason their largest banks are in trouble is that Europe ordered a debt haircut for Greek government bonds, many of which were held by Cypriot banks.

Now they feel like laboratory rats, say the Cypriots. They are convinced that the kind of bank account levy conceived of for depositors in Cyprus would never have been attempted on any other euro-zone member state. The prevailing feeling is that because Cyprus is small and weak, Europe felt it could get away with it.

The Cypriots were quick to assign blame. A cartoon in the Cypriot daily O Phileleftheros portrayed Merkel, Schäuble and International Monetary Fund (IMF) President Christine Lagarde as Huns with their swords drawn. A journalist with the same paper referred to as "fascist" Schäuble's characterization of the Cypriot business model as "no longer sustainable."

The German finance minister has become a symbol of the almost insurmountable differences between the Mediterranean country and Germany. "Unfortunately, the mutual perception of our countries is totally distorted," complains a Cypriot diplomat who lived in Germany for a long time. "Nowadays the German public only associates us with money laundering, the Russian mafia and oligarchs."

Victims or Perpetrators?

No Cypriot disputes that the island is a safe haven for foreign capital from around the world. They are convinced, however, that their country's business model differs only slightly from those of other financial centers like Ireland, Luxembourg and Great Britain. Island residents find it outrageous that Schäuble views Cyprus's low-tax model as a failure while a number of German companies profit from precisely that model. For instance, of the 80 foreign shipping companies in the port city of Limassol, 36 are German and only three are Russian.

"Many see Cyprus as nothing but a problem island that is bringing down the euro zone," says Andreas Athinodorou, who runs a tax and corporate consulting business in Nicosia. Last Wednesday, Athinodorou received more than 200 emails from concerned investors who "wanted to know whether their money is still safe with us, and yes, I was able to reassure them," he says. The "Cypriot business model," with the lowest corporate tax rate in the EU, will remain in place for now, says Athinodorou.

But that is precisely what Germany wanted to prevent. Berlin sees the Cypriots not as innocent victims but as being largely responsible for their current predicament. It is, after all, true that Cypriot banks lured billions into the country with low taxes, attractive interest rates and lax regulation -- and much of that money came from dubious sources. Cyprus was known for the fact that no one wanted to know exactly where the money had come from.

Late last year, a report by the BND, Germany's foreign intelligence agency, attracted attention when it portrayed Cyprus as a hub for money laundering. Wealthy Russians in particular were attracted to the favorable conditions and invested billions in Cyprus, often circumventing the Russian tax collector. According to the BND, 80 Russia oligarchs have sheltered their money on the island.

But citizens of other countries, especially Great Britain, also value Cypriot discretion. There is about €70 billion deposited in savings accounts with Cypriot banks. More than half of that, €39 billion, is in accounts with balances in excess of €100,000. European leaders were anxious to trim the island's banking sector to tolerable levels as quickly as possible. But Nicosia was keen to keep its financial industry intact.

Rigidity in Berlin

That desire goes a long way toward explaining President Anastasiades' stubbornness during the negotiations. To protect his banks and their major foreign investors, he initially opposed the Euro Group's plan to introduce a mandatory levy on savings deposits to bridge the funding gap. Ultimately, he acquiesced, but insisted that small deposits also be levied, only to claim afterwards that the hardliners from Germany had supported the inclusion of ordinary savers. In fact, it was Anastasiades who had insisted that large investors be protected as much as possible.

European leaders were astonished when, last Tuesday, not a single member of the Cypriot parliament voted in favor of the bailout package that included the one-time levy on deposits: 6.75 percent for accounts worth between €20,000 and 100,000, and 9.9 percent for those above that level.

Veteran European politicians also attribute the failure of the deal to the rigid position of the German government. "Other countries also have legitimate interests, which isn't sufficiently appreciated in Germany," says Luxembourg Foreign Minister Jean Asselborn. "We also accept that Germany sells a disproportionate number of weapons. In return, Berlin could show a little more understanding for the special situation of smaller countries."

Meanwhile, Berlin rejects all blame for the debacle, saying that those who don't want to be rescued simply cannot be helped. The ESM and the IMF cannot contribute more than the proposed €10 billion in bailout loans, says Berlin, arguing that this is the only way to achieve a debt level of 100 percent of GDP by 2020, as the IMF requires.

For this reason, the troika and the German Finance Ministry also discarded the Cypriots' proposed solution last week, which was to establish a bailout fund, using government and church property as collateral, which could then issue bonds independently. But critics unanimously agreed that the construct would simply amount to Cyprus taking on additional debt. "The proposal is worthless," sources associated with the troika said bluntly.

The Haves and the Have Nots

Instead, the ECB stepped in last Thursday, acting with unprecedented severity in giving a member state an ultimatum. Had Cyprus not submitted to the EU bailout program, the ECB would have cut off funding on Tuesday. To reinforce the threat, the ECB promptly froze its liquidity aid at the current level of €11.4 billion.

Even Southern European countries, normally in favor of generosity, agreed with the hard-line position. And the threat worked, with the Cypriot parliament and other leaders working tirelessly to come up with a deal.

Still, the real loser in the Mediterranean game of poker was the euro zone. Once again, leaders have demonstrated their inability to balance the interests of the currency union "haves" with those of the "have nots." Depositors, for their part, learned that legal protections on their savings accounts are not as concrete as they thought. And international financial markets learned that the term "systemically relevant" is extremely relative.

German Chancellor Merkel has likewise not emerged unscathed. In much of Europe, her image is that of an overbearing, heartless know-it-all who cares little for the suffering of average people. And at home, voters were likewise less than impressed. In the most recent public opinion polls, her Christian Democrats have lost two percentage points of support.


Translated from the German by Christopher Sultan

March 24, 2013 6:37 pm
London Whale is the cost of too big to fail
By Mark Roe

The report by the US Senate staff on JPMorgan Chase’sLondon Whaletrades, delivered last Friday, excoriates the bank for failing to make the full extent of the problem known to regulators and the public. But a focus on who knew what when can result in missing the big point: the cost of our too-big-to-fail banks is even heftier than is widely appreciated.

The conventional wisdom in many circles is that the losses caused by the trades are regrettable but we can all move on. After all, JPMorgan’s equity cushion can readily absorb it. Private shareholders and managers have paid the priceshareholders lost $6bn and several senior managers have black marks against their names. The episode is embarrassing but the bank can earn more than $20bn a year. “A tempest in a teapot,” said Jamie Dimon, its chief executive, last year.

But before the London Whale sinks from view, consider what would befall a conventional industrial company that suffered such a horrendous, expensive managerial lapse. If JPMorgan were in the business of making things, it would have already attracted significant corporate governance activity. The loss might be the trigger for a takeover and break-up effort.

It is certainly believed by many on Wall Street and in Washington that banking behemoths such as JPMorgan that deal in complex financial products have become too big to manage effectively. On a conventional analysis, if this were true, breaking them up would unlock shareholder value. The thinking goes that if synergies in the big financials are few and managerial degradation common, shareholders would, in time, have incentives to make that happen. Corporate governance activists have already circled around JPMorgan and other behemoths, thus far to little effect.

A closer look tells us why they cannot yet succeed in forcing big finance to spin off units to be better run, nimbler, more competitive and more effective in the manner of the big 1980s and 1990s industrial takeovers and conglomerate restructurings. Consider the incentives for restructuring too-big-to-fail financial firms. Suppose active shareholders were to decide that, say, a large bank would be better run if its biggest units were spun off into smaller ones

An active investor – in the mould of Carl Icahn or T. Boone Pickens might eye up the companies and naively agitate for a break-up. “A company this big and complex can’t be managed well, no matter how good the chief executive is,” they might say. “It is worth twice as much broken up.” But once they began working through the maths of a restructuring, they would find that shareholder values would not shift upwards in the way they might have predicted.

If the banking conglomerates were carved up into their constituent parts, the individual units would have a much higher cost of capital. Today, when financial conglomerates such as JPMorgan borrow to finance themselves, their creditors know the government will probably pay them back in full even if the bank fails because the systemic economic costs of their failing to do so is too large. Creditors therefore charge the conglomerate less. So the firm’s cost of capital becomes cheaper.

The dollar estimates of the too-big-to-fail subsidy to the largest banks range into very high numbers. One significant study, by economists associated with the IMF, suggested that banks could borrow 0.8 percentage points more cheaply because of their unshuttable status. The numbers may sound small but this subsidy can readily amount to half of the big banks’ profits. Moody’s, the credit rating agency, estimates Citigroup would be near junk bond status in credit quality if it were not for the fact that the state is assumed to back it. It is only because lenders lower their interest rate to too-big-to-fail companies such as Citi that its debt is anywhere near investment grade.

So that’s the choice for the shareholder: they can own a degraded, too-big-to-fail behemoth, but one with a hefty, not fully visible too-big-to-fail subsidy. Or they can have one that is well run, allocates capital effectively and does well by its customers, but does not enjoy the subsidy that creates much of the present shareholder value.

Seen this way, it is no accident that we have not seen break-up takeovers of too-big-to-fail financial institutions, even in the 1980s and 1990s takeover heyday. And we still do not see much restructuring, even when there are billion-dollar managerial lapses. Too-big-to-fail problems are thus even more costly than they have seemed to be so far.

We pay once as taxpayers, visibly and big when taxpayers’ billions bail out the biggest financial firms. And, long before then, we all pay continuously as financial consumers because the too-big-to-fail subsidy means that big financial conglomerates can be profitable for shareholders, even while being poorly run. As the London Whale has graphically shown, too-big-to-fail status insulates the financial sector from normal corporate and stock market constraints and discipline.

The writer is a professor at Harvard Law School

Copyright The Financial Times Limited 2013.

Debt-Friendly Stimulus

Robert J. Shiller

20 March 2013
This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

NEW HAVENWith much of the global economy apparently trapped in a long and painful austerity-induced slump, it is time to admit that the trap is entirely of our own making. We have constructed it from unfortunate habits of thought about how to handle spiraling public debt.
People developed these habits on the basis of the experiences of their families and friends: when in debt trouble, one must cut spending and pass through a period of austerity until the burden (debt relative to income) is reduced. That means no meals out for a while, no new cars, and no new clothes. It seems like common sense – even moral virtue – to respond this way.
But, while that approach to debt works well for a single household in trouble, it does not work well for an entire economy, for the spending cuts only worsen the problem. This is the paradox of thrift: belt-tightening causes people to lose their jobs, because other people are not buying what they produce, so their debt burden rises rather than falls.
There is a way out of this trap, but only if we tilt the discussion about how to lower the debt/GDP ratio away from austerityhigher taxes and lower spending – toward debt-friendly stimulus: increasing taxes even more and raising government expenditure in the same proportion. That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines.
This kind of enlightened stimulus runs into strong prejudices. For starters, people tend to think of taxes as a loathsome infringement on their freedom, as if petty bureaucrats will inevitably squander the increased revenue on useless and ineffective government employees and programs. But the additional work done does not necessarily involve only government employees, and citizens can have some voice in how the expenditure is directed.
People also believe that tax increases cannot realistically be purely temporary expedients in an economic crisis, and that they must be regarded as an opening wedge that should be avoided at all costs. History shows, however, that tax increases, if expressly designated as temporary, are indeed reversed later. That is what happens after major wars, for example.
We need to consider such issues in trying to understand why, for example, Italian voters last month rejected the sober economist Mario Monti, who forced austerity on them, notably by raising property taxes. Italians are in the habit of thinking that tax increases necessarily go only to paying off rich investors, rather than to paying for government services like better roads and schools.
Keynesian stimulus policy is habitually described as deficit spending, not tax-financed spending. Stimulus by tax cuts might almost seem to be built on deception, for its effect on consumption and investment expenditure seems to require individuals to forget that they will be taxed later for public spending today, when the government repays the debt with interest. If individuals were rational and well informed, they might conclude that they should not spend more, despite tax cuts, since the cuts are not real.
We do not need to rely on such tricks to stimulate the economy and reduce the ratio of debt to income. The fundamental economic problem that currently troubles much of the world is insufficient demand. Businesses are not investing enough in new plants and equipment, or adding jobs, largely because people are not spending enough – or are not expected to spend enough in the future – to keep the economy going at full tilt.
Debt-friendly stimulus might be regarded as nothing more than a collective decision by all of us to spend more to jump-start the economy. It has nothing to do with taking on debt or tricking people about future taxes. If left to individual decisions, people would not spend more on consumption, but maybe we can vote for a government that will compel us all to do that collectively, thereby creating enough demand to put the economy on an even keel in short order.
Simply put, Keynesian stimulus does not necessarily entail more government debt, as popular discourse seems continually to assume. Rather, stimulus is about collective decisions to get aggregate spending back on track. Because it is a collective decision, the spending naturally involves different kinds of consumption than we would make individually – say, better highways, rather than more dinners out. But that should be okay, especially if we all have jobs.
Balanced-budget stimulus was first advocated in the early 1940’s by William Salant, an economist in President Franklin Roosevelt’s administration, and by Paul Samuelson, then a young economics professor at the Massachusetts Institute of Technology. They argued that, because any government stimulus implies higher taxes sooner or later, the increase might as well come immediately. For the average person, the higher taxes do not mean lower after-tax income, because the stimulus will have the immediate effect of raising incomes. And no one is deceived.
Many believe that balanced-budget stimulustax increases at a time of economic distress – is politically impossible. After all, French President François Hollande retreated under immense political pressure from his campaign promises to implement debt-friendly stimulus. But, given the shortage of good alternatives, we must not assume that bad habits of thought can never be broken, and we should keep the possibility of more enlightened policy constantly in mind.
Some form of debt-friendly stimulus might ultimately appeal to voters if they could be convinced that raising taxes does not necessarily mean hardship or increased centralization of decision-making. If and when people understand that it means the same average level of take-home pay after taxes, plus the benefits of more jobs and of the products of additional government expenditure (such as new highways), they may well wonder why they ever tried stimulus any other way.

Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the second edition of which predicted the coming collapse of the real-estate bubble, and, most recently, Finance and the Good Society.