Cyprus: An Exercise in Politicians' Logic

The debacle in Cyprus has been one of the most interesting and baffling exercises in politicians' logic in recent times.  It shows how much politicians are fans of round numbers, regardless of its practicality:

1) Germany said the euro zone should not lend more than EUR10bn to recapitalise Cyprus's banks, even though Cyprus needs about 50% more than that.

2) The IMF didn't want Cyprus's debt to GDP to rise above 100%, even though it's been above 100% for almost its entire time in the EU (and is currently at 140%), effectively defying basic arithmetic.

3) The president of Cyprus was adamant that the tax levied on big depositors (read Russian oligarchs and Greek tax dodgerds) shouldn't be more than 10%, even though it was their fast money coming into Cyprus's banking system which has caused the banking crisis in the first place.  

4) Senior bondholders lose nothing, even though depositors are supposed to be paid ahead of bondholders.

The number of Cypriots MPs voting for the bailout package?  Zero...  Go figure, you mean none of the MPs thought that the four criteria laid out above made sense?  What does this all mean?  Small depositors take a big hit for a problem that they didn't cause.  No wonder people are taking to the streets...I'd riot too if the government tried to do that to me!

Now if you're a Cypriot, things haven't been that bad until now.  GDP  growth was fairly strong until the financial crisis (see below data from Trading Economics); healthcare, tourism, shipping, and financial services have done well for the country.

Plus, though the country had high debt to GDP ratios historically (why did the EU let them join in the first place with a debt to GDP of 180%?!), it came down dramatically over the past decade until the financial crisis hit and the government had to bail out the banks.

On top of this, the banking problems weren't because of excessive borrowing locally, it was due to foreign deposits coming into the country which the banks then lent back out overseas.  Unfortunately, the banks chose Greece as a main destination for a lot of the cash...oops...  When the eurozone bailout of Greece forced losses on Greek government debtholders caused austerity which increased non-performing loans, this badly hit the Cypriot banks.  So one could view this bailout to be merely an extension of the Greece bailout.

To make it even more ridiculous, the country's central power plant was blown up by an explosion at the naval base next door in 2011.  Evidently, the navy didn't think it was a problem stored munitions next to the power plant!  So you have to feel for the average Cypriot on the street, who's wondering why they are getting robbed for something they didn't cause.

Now, before you start shedding tears for the Cypriots, they weren't exactly the epitomy of fiscal prudence either.  They've run a current account deficits as long as one can remember, i.e. they spend more than they earn.  Plus, you have to wonder what they were thinking letting their banking sector get to 13 times the size of their GDP!  Well, it's because they made a pretty good living off of all the foreign money which was coming in, even if they didn't realise it.

They also haven't exactly been model citizens of the EU.  There's a reason why Russians launder their money through Cyprus...because the country wants them to as long as it gets a cut.  They've also backed Russia against the will of the other EU nations...evidently Russia assassinating people using radiation poisoning wasn't enough to make them think about who they should get into bed with.  The EU and the United Nations also had an agreement to merge Northern Cyprus, occupied by the Turks since 1974, with the Republic of Cyprus, but Cyprus nixed the deal just to stick it to the Turkish Cypriots.  Now Cyprus is giving two fingers to the EU and trying to bargain with Russia in exchange for a naval base and potentially rights to gas fields which haven't been developed yet.  So it's not a surprise that the EU wants its pound of flesh from them.

This raises the question, does the EU really need to cave in to Cyprus for a more lenient deal?  I agree that it makes no sense to screw small depositors...it would be disastrous for confidence in the financial system if the EU goes back on its EUR 100,000 deposit guarantee.  But why not stick it to large depositors?  Would taxing Russian money launderers and Greek tax dodgers be a bad thing?  It certainly would be poetic justice to hit the people which have benefitted from the lax regulations and tax avoidance of the past two decades.

The ECB is worried about the effect on confidence in other weak Eurozone countries if they don't back Cyprus.  But is it really that much of a problem?  I don't think so.  In a banking crisis, regulators often let some banks go to the wall (either they refused to be helped or are beyond help) but state concretely which banks they will save.  As long as the ECB does this, there's no reason why they can't let Cyprus go bankrupt but back other nations.  It would certainly give people in say Italy a nice compact example of what happens when you don't take the EU bailout...you leave the Euro currency and suffer a bad devaluation, and you literally will lose half your saving deposits as the banks won't have the money to pay you back since no one is willing to lend to them.  It's not a pretty picture, but perhaps letting Cyprus go to the wall if they remain obstinate will give policymakers more credibility that the reforms they are demanding are necessary (though the austerity they are also asking for doesn't make a whole lot of sense right now).  Otherwise, the citizens of these countries will keep blaming someone else as the cause of their problems rather than face the reality that they can no longer live beyond their means.

Misunderstanding about the UK's Austerity Budget

Ahead of Chancellor George Osborne’s budget for 2013 which is supposed to come out on the 20^th, there has been a lot of criticism of the “austerity” being imposed by the government.  Many are calling for a change of direction; Nobel Laureate Paul Krugman said that the austerity drive is “deeply destructive.”  As a friend of mine noted (and rightly so), growth should be the main priority, so how can growth happen if the government is cutting back on spending?  However, this is only part of the story, so I wanted to put this all in prospective as most people are still of the wrong mentality.

First, government spending is still growing, as shown in the table below, so the government isn’t actually shrinking spending, only shrinking it as a percentage of GDP.

Second, even with the cutbacks, government spending as a percentage of GDP is still near the top of its historical range over the past 40 years (see table below)…hardly austerity.  The main problem is that the previous Labour government increased spending significantly as a percentage of GDP even though the UK was going through its best and longest growth period for the past 40 years.  They ran significant fiscal deficits during the good times, leaving nothing for the bad times.  They compounded this problem by financing a big part of the spending increase with taxes on the financial sector and encouraged the financial sector’s growth with “light touch” regulations and increased consumer indebtedness.  The Labour opposition are currently proposing more of the same, which has been shown to be detrimental to the economy.  So before people start running towards the Labour Party because they like what they hear, be careful…Ed Miliband and Ed Balls have the economic credibility of Argentina…or Venezuela.  Growth by borrowing is always easier than real growth via increasing economic productivity; this is a lesson learnt time and again in emerging market economic crises and being learnt now in the Eurozone and other developed market crises.

Third, the UK’s private sector debt has more than doubled as a percentage of GDP over the past 15 years, which is obviously unsustainable.  Basically, people have been spending beyond their means, and government spending, regardless of an austerity budget or not, isn’t going to change the fact that UK consumers will implode upon themselves if they continue this trend.  In this way, the austerity budget is useful in that it is as least forcing the debate of debt consolidation and spending within one’s own means.

These three reasons show that the government is right to sound the austerity alarm bell.  It’s not a matter of opinion; it’s a mathematical fact.  Anyone who tells you differently just simply doesn’t know what they are talking about.  But we come back to the question, how do you grow the economy if you have to cut back on borrowing and spending?  This is where the current Tory-Lib Dem government falls down on.  It has done a good job explaining the need for austerity in terms of consumption, but it doesn’t have a coherent strategy (or much of a strategy at all) for how you improve economic growth.  They hope that growth will come through confidence from austerity.  President Herbert Hoover in the US tried that during the Great Depression…it didn’t work too well to put it mildly.

There are generally three answers to this conundrum.

One is that the main way of truly increasing sustainable GDP growth is through improvements in productivity.  The UK economy, like other developed economies, is dominated by the service sector and by government (77% of the economy).  It should also be noted that these two sectors are notoriously the least productive in the economy (the table below provides an indication of how service sector productivity lags significantly).

As any foreigner will tell you, services in the UK are expensive, the quality is terrible, and the transport system is positively Third World.  There is a lot of scope for improving productivity here, and the government needs to have a plan to tackle inefficiencies in a wide variety of areas.

The second answer is devaluation of the pound sterling.  If your industries are generally uncompetitive, then making them cheaper will attract business.  This is what happened after the pound left the Exchange Rate Mechanism in 1992 and sharply devalued (see the graph below).  The UK economy, which had been held down by the imposition of high interest rates to defend an overvalued currency, recovered quickly after the devaluation (in fact, this was the last recession prior to the financial crisis).

However, benefitting from a devaluation is easier said than done.  The US and the Eurozone are weak and so are trying to devalue as well, while the many emerging market countries are purposely trying to hold their currencies down to prevent themselves from becoming uncompetitive.  Also, the UK has lost a significant portion of its export sector since the early 1990s, so the benefit of a devaluation will take time.  Still, the UK is doing a better job of devaluation than most (see graph below); the Bank of England has pushed the pounds to near the bottom of its trading range over the past 20 years.

Finally, government should cut back on consumer-related spending, but it doesn’t necessarily need to cut back on spending overall for the time being.  As shown in the graph below, UK government debt to GDP is high but not excessive compared to historical standards (though it should be noted that the prior periods had strong population growth which helped economic growth, something which is not likely in the near future).  Spending on investment which can increase productivity or economic capacity if done in the right areas, can be easily offset by the benefits.  The UK has significantly underinvested over the past 15 years (effectively living off of its past investments), part of the reason why the economy has difficulty growing and why inflation is high for a period of such slow growth.  So if the government maintained spending levels but redirected it from consumption to investment, then the economy should recover more strongly (though note, this stills means consumption spending on things like benefits, NHS, etc will need to go down as a percentage of GDP, so the message of austerity still rings true).

So the Tory-Lib Dem coalition are half right and half wrong in their economic policies (whereas the Labour Party are just completely wrong, but then, I can’t recall Labour’s economic policies ever being right after Clement Attlee’s government).  The government has rightly cut consumption spending, but it has not developed a strategy for improving investment spending and increasing productivity.  This is what George Osborne’s new budget should focus on.