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Would a Euro Area Banking Union Have Saved Cyprus?

Whether a euro area banking union would have saved Cyprus from its recent TROIKA (of European Commission, European Central Bank and IMF) tragic treatment is a very interesting question. If it would, then clearly a move towards a banking union, as part of the construction of a political union should be a major component of the reconstruction of the euro area. As we argued in our March 2013 blog, the European Union (EU) summit meeting, 28th/29th June 2012, took a number of decisions in terms of a possible euro area banking union. The most relevant decision was the creation of banking supervision by the European Central Bank (ECB), banking licence for the European Stability Mechanism (ESM), and financial assistance by the ESM to governments, members of the euro area, when in financial difficulty. The banking supervision, however, will not come into full operation before 2014. ESM member states would then be able to apply for an ESM bailout when they are in financial difficulty or their financial sector is a threat to stability and in need of recapitalization. This is exactly the problem with the recent Cyprus problem, as we now elaborate.

Essentially the major problem in Cyprus has been the size and insolvency of its banking sector. It is far too big in relation to the total economy (ten times its annual GDP is often quoted by the TROIKA; being big relative to economy means its assets and liabilities relative to GDP are large); it is also the case that as an off-shore financial and business centre, the Cypriot banking attracted a significant amount of foreign deposits. The first feature poses the danger of a ‘systemic risk’ for the entire economy when one or more banks fail. The second feature exposes Cyprus to accusations, such as those from politicians in Germany and elsewhere that Cyprus has become a ‘money-laundering’ centre within the European Union. By the summer of 2012 it became clear that the two biggest domestic banks in Cyprus were in trouble because of huge losses from the exposure of their branches in Greece, in view of the depressed macroeconomic conditions there, promoted by TROIKA; also in view of the ‘haircut’ of the Greek sovereign debt, of which Cypriot banks had acquired a great deal by 2010. This mixture of wrong decision-making by Cypriot bankers and bad luck created the need for bank re-capitalisations. As a result, Cyprus applied for financial help from its partners in the euro area in the summer of 2012.

The request by Cyprus for a bail-out has certain unique features. The tiny economy of Cyprus requested 17.5 billion euros which, by contrast to the previous Southern European bail-outs, was a comparatively trivial sum in absolute terms. It was, nonetheless, quite large, nearly 100%, when expressed as a percentage of Cyprus GDP. The initial negotiations between the TROIKA and the outgoing government of Cyprus were accompanied by political noises from Germany implying that the German electorate was fed up with having to hand over money to the Southern European periphery yet again. The reason as to why the heavily indebted southern periphery of Europe was morally ‘undeserving’ of financial help was simply undesirable money-laundering. The argument produced is that hard working and prudent German tax payers should not be expected to rescue an overblown banking sector in Cyprus, which became a ‘tax haven’ for wealthy non-Europeans. These are especially Russians, whose deposits in Cyprus are thought to be of the order of 25bn euros, an amount that is almost one-third of the total deposits in the Cyprus banks. The depositors in the Cyprus banking system should be partly expected to rescue their economy, a proposal that was apparently initiated and promoted by the IMF part of TROIKA. The European Commission was reluctant on this score, fearing a bank run in Cyprus and potentially elsewhere in the euro area. Such a plan, it is argued by TROIKA, helps to reduce the unsustainable large banking and financial sectors of Cyprus. It is also the case that to the extent the ‘bail-in’ of the banks in Cyprus is successful it will introduce some market discipline in banking. By sending the message to all depositors in all banks that if a bank needs re-capitalisation they may be asked to bear some of the cost, the depositors will be forced to take more care where they ‘park’ their savings. Unfortunately the world is a much more complicated place to rely for such arguments to be uncontroversial. This is particularly so in the world of money and finance. In any case, and as the editorial of the Financial Times (18 March 2013) rightly commented “instead of throwing Cyprus a life-buoy, leaders put a millstone around its neck”.

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The Inflation Dog Didn’t Bark, But What About the Others?

Erinc Yeldan, Guest Blogger

The IMF released the April edition of its World Economic Outlook (WEO). One of the key analytical chapters (Chapter 3) of the Report is titled “The Dog that Didn’t Bark: Has Inflation Been Muzzled, or Was It Just Sleeping?” Its main argument (or rather sort of a mystery that needs to be resolved, in the words of its authors) is that over the course of the previous crisis episodes we used to witness severe increases in unemployment along with a simultaneous fall in inflation. Yet, during the current great recession there has been very little movement in inflation, while unemployment rates soared almost everywhere; —hence the metaphor: inflation (the dog…) does not respond (… bark). And the alleged mystery is but why?

The WEO suggests two candidates for explaining the mystery: the first one is based on the “structural unemployment has shifted” hypothesis, arguing that “the failure of inflation to fall is evidence that output gaps are small and that the large increases in unemployment are mostly structural.” The logical policy implication of this argument is that “… the monetary stimulus already in the pipeline may reduce unemployment, but only at the cost of overheating and a strong increase in inflation—just as during the 1970s”. Yet, by itself this argument does not provide much of an explanation, as the underlying causes of this structural shift still remains unanswered.

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On the Road to Damascus? Ambiguity and Continuity at the IMF

Cornel Ban

The most recent high profile form of target practice for the expansionary austerity thesis uses a great deal of IMF research as ammunition. A senior IMF level official who managed the Fund’s involvement during the Irish crisis blasted Europe’s policy of austerity and issued dire warnings about a gloomy future if the current course of action is maintained.Has the crisis really changed the International Monetary Fund’s policy advice? The main finding of an international workshop that took place recently at Boston University was that while some remarkable changes did in fact occur in IMF policy advice, they were too modest to suggest that an economic paradigm change is imminent.

The contributors noted that this international organization took a half-step on capital account regulation, became more open to the preferences of developing countries, relaxed its erstwhile strict commitment to austerity and has become a lot more reserved towards cross-border banking and the involvement of private sector consultants in its financial surveillance teams. At the same time, they found that the Fund has narrowed the scope of its programs to a predominantly orthodox economic policy agenda, continued to make counter-cyclical policies conditional on bond market sentiment and contributed to the weakening of recovery via its continued discrimination in favor of foreign creditors.

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How we learned to stop worrying and love capital controls: From Cyprus, to Iceland, to Brazil

Ilene Grabel

There’s a political cartoon that I’ve had in mind these days when I think about recent changes in the international political economy of capital controls. Picture a sailboat in stiff winds on rough seas. The wind in the sails is labeled something like “Cyprus, Iceland, Brazil, China, or the Global South.” The boat is labeled “S.S. Capital Controls.” The International Monetary Fund’s (IMF) Managing Director Christine Lagarde is at the tiller, and she barks at her worry-stricken shipmate—“No, don’t trim the sails!” But we also see that the ship is trailing its anchor, which is labeled “Neoliberalism.”

I begin with this image because I think it captures well the conflicted processes surrounding capital controls during the current global financial crisis. Many extraordinary things have happened during the crisis. One is that we’ve come to learn an awful lot about countries like Iceland and Cyprus, countries that we could safely say weren’t even at the periphery of any discussions of the global financial system until 2008. Another is that capital controls (so long anathema to neo-liberals) have been successfully “re-branded” as a tool of prudential financial management, even within the corridors of the IMF. In a recent paper, I examine the myriad factors that have enabled this re-branding. As with most rebranding exercises there is uncertainty about whether the framing will prove sufficiently sticky, especially in the context of tensions and countervailing impulses at the IMF and elsewhere.

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The WTO “Papal” Conclave

Robin Broad

Let’s start today’s trivia quiz with the Rome Papal conclave: Name 2 of the last 3 popes. And, for a bonus question, tell us something about the process by which a new pope is chosen.

And now let’s switch to the Geneva WTO Director General conclave – or more accurately the choosing of the new head of the World Trade Organization: Name 2 of the last 3 WTO heads. Tell us something about the process by which a new Director General of the WTO is chosen. And, wild card question, name even 1 of the 9 candidates vying to be head of the WTO.

If you are like most people I surveyed, you know more about the selection of the pope than that of the WTO head. And, even if you do know some of the WTO candidates, you probably don’t have much of a sense of who, if anyone, might be a better candidate for those of us who care about economic governance that balances social, environmental, and economic issues.

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The Perils of Technocracy and the Future of European Integration

Daniela Schwarzer

The current crisis in the euro area, the reforms governments have to implement, and the high unemployment levels in many member states are weakening the legitimacy of European integration. In my last post, I described how this output legitimacy crisis unfolds.

The debate about legitimacy and democratization in the EU traditionally focuses on the input side. As crises have surfaced, the flaws in the governance structures have also fuelled this old debate. In fact, it can hardly be argued that citizens have the chance to effectively influence the developments that deeply affect them, given the national fragmentation of decision-making and the resulting hazardous nature of macro-economic developments.

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Central Bank Autonomy: A Dangerous Mirage

Alejandro Nadal

The global financial crisis is breathing and evolving. In Europe it is treated as a sovereign debt crisis. But given the fact that the crisis exploded in the midst of the private financial sector, how did we get here?

Four decades ago, more precisely on January 3 1973, a new law on central banking was approved in France. The new statute for the Banque de France contained critical provisions for the independence of the monetary institute. Article 25 turns out to be particularly relevant for today’s debate on Europe’s crisis. It stated that the Treasury would not be able to resort to the Banque de France to borrow money.

This represented a historical transformation in public finance and left the State at the mercy of the private commercial banking system. Instead of using the money emission capacity of the central bank, the French government had now embarked on a new course, one that turned out to be a milestone in financial liberalization. Many other countries followed this example. Incidentally, when the law was passed Georges Pompidou was the President of France. He had been director of the Banque Rothschild between 1956-1962, a fact that generated suspicion as to the motivations of the Loi 73-7 of 1973.

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Is the Euro Crisis Over?

Robert Guttman, Guest Blogger

A strange calm has settled over Europe. Following Mr. Draghi’s July 2012 promise “to do whatever it takes” to save the euro, which the head of the European Central Bank followed shortly thereafter with a new program of potentially unlimited bond buying known as “outright monetary transactions,” the market panic evaporated. Since then super-high bond yields have come down to more reasonable levels, allowing fiscally and financially stressed debtor countries in the euro-zone to (re)finance their public-sector borrowing needs a lot more easily than before. Even Greece has been able to borrow in the single-digits for the first time in three years.

This calming of once-panicky debt markets has led to optimistic assessments that the worst of the crisis has passed. Draghi himself declared at the beginning of the new year that the euro-zone economy would start recovering during the second half of 2013. He talked of a “positive contagion” taking root whereby the mutually reinforcing combination of falling bond yields, rising stock markets and historically low volatility would set the positive market environment for a resumption of economic growth across the euro zone. Christine Lagarde, as the head of the IMF part of the “troika” (i.e. ECB, IMF, and European Commission) managing the euro-zone crisis, declared at the World Economic Forum in Davos a few weeks ago that collapse had been avoided, making 2013 a “make-or-break year.”

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New IMF research validates critics’ concerns

Ilene Grabel

I’m imagining that things have gotten a little chilly for some in the IMF’s cafeteria. Why? Two important studies coming from different quarters of the Fund validate important and long-standing criticisms of the institution.

The first is a recent report by the IMF’s Independent Evaluation Office (the IEO), an internal body that conducts notably refreshing and often critical audits of various aspects of IMF performance. In an especially hard hitting (and on target) report, the IEO takes on the IMF’s work on exchange rate issues and specifically on “excess” foreign reserve accumulation in some countries during the period 2000-2011. After 2009, we should recall, IMF economists began to argue that excess reserve accumulation contributed to global financial instability. The report provides support for what many Fund watchers have long argued—namely, that the Fund has used the charge of excess reserve accumulation as a Trojan horse to advance the interest of its most powerful members in pushing countries like China to move toward more flexible exchange rates.

The same IEO report finds that the Fund’s analysis of excess reserve accumulation was analytically deficient on several grounds. First, the report’s authors argue that there is scant academic evidence for setting upper or lower limits to countries’ reserve levels (though the IMF has attempted to do so via a reserve adequacy metric since 2011). Second, the obsessive focus on reserves meant that Fund staff overlooked the precautionary motives that caused some countries (in East Asia and elsewhere) to amass massive reserves.

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The IMF’S Institutional View On Capital Flows: Back To The Future

Yilmaz Akyuz

As the crisis in advanced economies (AEs) has laid bare the deficiencies of unfettered financial markets and developing countries (DCs) have started exploring ways and means of counteracting destabilizing capital inflows triggered by quantitative easing and historically low interest rates in major AEs through various measures, the IMF has been compelled to reconsider its position on capital account liberalization. After two years of pondering it has now come up with an Institutional View, discussed in its Executive Board and endorsed by most Directors. It is meant to guide Fund advice to members and Fund assessments in the context of surveillance, while it is also reiterated that members have no capital account obligations under the Articles of Agreement.

This new view brings no fundamental change in the long-held position of the Fund regarding the benefits of free capital movements. It is now recognized that there may be circumstances when capital movements may need to be restricted by Capital Flow Management Measures (CFMs), but such measures need to be deployed only as a last resort (even though the new text avoids using the term) and on a temporary basis. Countries with long-standing and extensive CFMs are advised to liberalize in order to benefit from capital movements. The Fund goes even further and encourages premature liberalization: “a country could make progress towards greater capital flow liberalization before reaching all the necessary thresholds for financial and institutional development, and indeed doing so may spur progress in these dimensions.”

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Would a Euro Area Banking Union Have Saved Cyprus?

The Inflation Dog Didn’t Bark, But What About the Others?

On the Road to Damascus? Ambiguity and Continuity at the IMF

How we learned to stop worrying and love capital controls: From Cyprus, to Iceland, to Brazil

The WTO “Papal” Conclave

The Perils of Technocracy and the Future of European Integration

Central Bank Autonomy: A Dangerous Mirage

Is the Euro Crisis Over?

New IMF research validates critics’ concerns

The IMF’S Institutional View On Capital Flows: Back To The Future

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