Saturday, March 30, 2013

Saturday Morning Musings - lessons from the Cyprus story

Today's Saturday Morning Musings focuses on Cyprus and bank regulation.

At times I find it hard to believe that I worked as a professional economist for more than twenty years before events took me in different directions. I make this point now because my knowledge of parts of economics sits frozen in the past until events force reactivation. A case in point was the onset of the Global Financial Crisis. This drew me back into macroeconomics as I sought to understand just what was happening and just what it might mean for Australia. Now the same thing has happened again.

Over at his place, Winton Bates began a discussion on bank regulation. This drew me in, and then when the Cyprus crisis broke I wrote two short posts on that. The discussion in comments reminded me just how little I knew and forced me to go searching for understanding. In doing so, I had to dust off my knowledge of the economic theories of money. Those theories sit frozen in time before the more sophisticated later analysis. Maybe, just maybe, they are not the worse for that. Australian Joint Stock Bank

This is a picture of a bank note issued by by the Sydney based Australian Joint Stock Bank for distribution in Queensland. When I was a child, old Mr Wallace used to come weekly to do our garden. He had been a young man during the depression of the 1890s. He remembered the crash clearly and talked about Bank failures.

This was a pretty big crash, the most severe in Australia's history. In a very good Australian Reserve Bank research report (A history of last resort lending and other support for troubled financial institutions in Australia) issued in October 2001, Bryan Fitz-Gibbon and Marianne Gizycki described it in this way:

The depression, which saw real GDP fall 17 per cent over 1892 and 1893, and the accompanying financial crisis, which reached a peak in 1893, were the most severe in Australia's history. The overextension of the 1880s property boom and its unravelling led to an abrupt collapse of private investment in the pastoral industry and urban development and a sharp pullback in public infrastructure investment. A fall-off in capital inflow from Britain, adverse movements in the terms of trade and drought in 1895 accentuated and prolonged the depression.

Sound familiar? Change dates and some of the detail and you could be talking of the Euro crisis. Australian history actually does have something relevant to say, for we have been through many of the challenges faced by the Euro.

The Role of Money

In the simpler world in which I first did economics, two key attributes of money were as a means of exchange and a store of value.

As a means of exchange, money replaced barter by providing a measure of value independent of relative exchange values. A pair of shoes or a sword or shield no longer had to be exchanged for, say, so much fish. Both sides of the exchange and of all exchanges could now be valued via a common denominator. Such a simple concept, but one that had profound results, for it is the basis of modern markets.

As a store of value, money further simplified things. Pre-money, your financial worth was measured by physical things, land or olive oil or cattle. That was fine, but it was complicated and limited. With money, and early money was still physical, you had a means to simplify things. Now you could hold some of your wealth in a form that was easily exchanged for other things.

With time, money as a store of value was further simplified by turning it into pieces of paper issued by a trader, a bank, or some other form of financial institution. Ultimately, the bank note was born, initially the issue of paper money was largely private, but it was sufficiently profitable that private money came to be replaced by Government money beginning in China. During this long transition, banks and bank deposits became money. The bank issued notes, but also accepted deposits on call that themselves became money. The idea of cash at bank was born.

Money's role as a means of exchange and a store of value facilitated both the creation of credit, lending, and commercial transactions. Banks became the key enabling device for both credit creation and commercial transactions. Most recently, developments in computing and communications technologies has further cemented that role. For all practical purposes, we have no choice but to hold our money at bank or some other deposit taking institution with electronic payment facilities. Technically, we have lent the bank our money, but for practical purposes that's our cash.  

This is not a lecture on the history of money. Rather, my focus is on the role of money and its links to the banking system. 

The Australian Experience

In the Australian experience outlined by Bryan Fitz-Gibbon and Marianne Gizycki, you will see clear recognition over time of the role of money as both a medium of exchange and a store of value. Prior to Federation, each colony had its own banking system that was central to the life of the colony. Each banking system was subject to periodic crises of which the depressions of the 1840s and 1890s were the most severe.

Both Colonial Governments and the note issuing banks themselves were involved in the management of these crises. If you look at the history, you will see that attention focused on protection of the value of the bank notes issued, on the protection of depositors and on the avoidance of bank runs and liquidity crises. Various techniques were used including lender of last resort facilities. However, there was also clear recognition of the risk of moral hazard; some banks were allowed to fail, others were reconstructed using a variety of mechanisms. Protection of the value of notes and of deposits was central to reconstruction. While note holders and depositors did sustain some losses, a remarkable number of the reconstructions actually resulted in note holders and depositors receiving a full return.

Cyprus vs Colonial Australia

To my mind, and unlike the Australian Colonial experience, those crafting the Cyprus response have somehow managed to attack every single element that I have talked about in both the role of money and that of the banking system. The results are likely to be profound and long-lasting, especially on Cyprus itself. 

You can get a feel for the difference between Colonial Australia and Cyprus from this Reuters quote from the German Finance Minister Wolfgang Schaeuble:

"Together in the Eurogroup we decided to have the owners and creditors take part in the costs of the rescue - in other words those who helped cause the crisis," said Schaeuble, one of the architects of the euro zone's response to a debt crisis now in its fourth year.

Note that all depositors are counted as creditors.This is a fundamental shift. 

Mr Schaeuble also said:  "Cyprus is and will remain a special one-off case,.....Savings accounts in Europe are safe."  Really? No, I don't believe him either. In practice, ordinary people have limited choices, but they will shift with time.    

A Single Currency?

The core concept in the Euro was the creation of a single currency that would help unite Europe and facilitate trade and other economic activity across a widening area. Consistent with this, the Wikipedia article on the Euro states:

Euro banknotes do not show which central bank issued them. Eurosystem NCBs (National Central Banks) are required to accept euro banknotes put into circulation by other Eurosystem members and these banknotes are not repatriated.

Well, it appears that this is is not quite right. It seems that individual Euro notes issued by individual central banks can be identified by a country code in the serial number. Now this shouldn't matter all that much. But it does. Here I want to quote from one of my commenters:

If you are travelling (and purchasing Euros in advance from an Australian bank), beware of any Euro note with a letter 'G' prefixing its serial number. These are Cyprian Euros. Best (if you can) to go for 'X', 'P', 'L', or 'N' prefixes - respectively denoting Germany, Holland, Finland and Austria as the country of issue.

In theory, this numbering system should not matter. After all, the system requires European NCB's to accept all Euro banknotes. In practice, Cypriot G Euros are likely to be discounted, as will  notes from other weak countries.

Impact of the Common Currency

Australia became a single currency zone with Federation, although it would be 1911 before the first Australian bank notes were issued. The combination of custom union with a common economic currency had significant redistributional effects, with economic activity and income redistributed from the country to the metropolitan centres, from the non-industrial states to the industrial states.

The introduction of the Euro in 1999 has had somewhat similar results, with  some shifts of income from the south to the north, although this was to a degree disguised by other effects. This includes revenue transfers to the peripheral economies. The problem is that unlike Australia where there were only six states that were relatively small economic units, the Euro covers many more states and a much larger economic zone. Further, the political decision making structures are far more complicated. In a way, the Euro needed more time to evolve than was allowed.

The Euro egg cannot easily be unscrambled. It really is just so much easier doing business or just travelling in Europe because of the Euro. The pains of exiting the Euro are also considerable. However, unless a way can be found of simplifying decision making systems, some break-up of the Euro would seem almost inevitable.

A Regulatory Mess

Cypriot banks operate in a multi layered regulatory system. They were subject to Government policy and Central Bank supervision on Cyprus. Then you had the EU and the European Central Bank. Beyond that were global changes to regulation including Basel III. Each layer had different approaches and rules. Further, regulatory approaches were overlaid by other policy approaches including the responses to the Greek debt crisis.    

Keeping things very simple, Cyprus is a nation. It's Government is responsible to the Cypriot people. The buck starts there. This includes crafting responses based on the Cypriot national interest independent of other layers. This isn't easy. It includes making compromises, and this bail-out was a compromise, where immediate pain is suffered for hopefully longer term gains.

Then at the next level we have the EU. The EU has to look after what it perceives to be the interests of the Eurozone as a whole. But in doing so, it needs to take into account the impact on its constituent parts. How does it manage the conflict between minorities (in this case Cyprus) and the broader whole?

Then we have the broader regulatory frame work. How do you manage the conflict that might arise between the need to make a global system work and European interests and then, within that, Cypriot interests?

The short answer is that you cannot! All you can do is to be very clear on the principles that you are using and the consequent implications. And that, to my mind, is where the Cyprus "solution" failed. It just wasn't thought through.                               


Winton Bates said...

A fascinating post, Jim!

It is interesting that depositors emerged relatively unscathed from the banking crises in Australia in the 19th century, despite the absence of a central bank to ensure liquidity and government fiscal policies that were probably pro-cyclical.

I suspect that the reason was that shareholder equity was generally a much higher proportion of bank assets then than it is now.

Jim Belshaw said...

It is an interesting story, Winton. You may be right on the gearing question, we would have to look at balance sheets to be sure. But Governments were involved, as well as cooperative bank action. So there may not have been a central bank, but there were equivalent responses.

I think that one of the take home lessons that I drew was the importance of flexibility. A second the need for clarity in response. In Cyprus, the response mixed things together. The package was not a bank rescue but a broader state rescue package. That's what I don't fully understand.