It is hard to do deposit levies in a clean fashion: Barry Eichengreen.
Mr Eichengreen, is the rescue package for Cyprus by the EU and the IMF sensible?
There had to be a bail-in of depositors. Without it, Cyprus would have been stuck with a debt it could not repay. But at the same time, it is terrible and outrageous that small depositors should be among those bailed in. The EU has a deposit insurance accord for small depositors in all member states. This agreement has been torn up. The consequences for confidence in the short run and the banking union in the long run are negative.
Would it be better to bail in bondholders, or to raise the limit of the deposits that are bailed in?
I think both these alternatives would have been better. As we have seen in the case of Greece, restructuring of sovereign bonds is possible. This would have allowed to reduce the government debt load and therefore the contribution from depositors. And more importantly, a much heavier levy on big depositors could have been applied.
Why was it not done this way?
The problem was the unwillingness of both the EU and Cypriote authorities to contemplate that possibility because of the fact that a bond restructuring cannot be done on a weekend. A bond restructuring and a debt exchange would require many weeks of preparation, and then many more weeks of implementation.
Is Cyprus really a unique case?
Yes, I do think that Cyprus has distinguishing features not shared by Spain or Italy. For instance, it has this very large off-shore deposits coming from Russia. The idea of targeting a levy of 9,9% on large deposits was designed to take advantage of that special feature, and to signal that Cyprus would no longer function as a money laundering centre. But the worry is that the reliability of the EU-guarantee for deposits under 100’000 € has been called into question. From that point of view, there is nothing special about Cyprus.
Cyprus is a tiny economy. Is it still a dangerous precedent?
It is obviously dangerous. For if you ask the question whether the deposit guarantee is worth the paper it is written on, the answer now is: maybe, or perhaps not. There are now much more troubling questions about the EU deposit guarantee than last week. From now on, if there are debt problems in another member state, the question will be asked whether depositors are bailed in. We do not know the answer, but we know depositors are much more uncertain than they were before.
Do you fear contagion? Have bank runs become more likely in other countries?
Now, depositor insurance does not automatically provide the confidence any more. And where small depositors are not confident, bank runs start to be conceivable. Depositors do not know what tomorrow will bring and whether the ECB will provide however much money the Italian central bank needs to backstop its banks in the event that deposits begin to flee.
Do you expect capital flight?
My best guess is that we will not see mass bank runs in Spain and Italy or elsewhere in the Euro Zone. And if we see the beginnings of it, we will also see a new commitment of the ECB that it will do whatever it takes to ensure that Spanish and Italian banks can pay out what they owe their depositors. But there could be a resurgence of the kind of excitement that we saw last summer.
What does the Cypriote rescue package mean for the planned European banking union, which includes a deposit guarantee?
It is the most powerful reminder of the importance of a common deposit insurance scheme for the Euro Zone. If we ever needed a demonstration of how important that is and what problems otherwise a national banking system can slip into, then Cyprus is a demonstration. But at the same time, the outcome makes you wonder whether the Finnish and the German authorities would ever be willing to agree to a banking union. This is the standard Euro Zone problem in a nutshell: to make the monetary union work, you need to move towards a banking union − you need an element of fiscal union.
Is time slipping away?
Germany and Finland seem to say: not so fast. Not until we have common supervisors and move in the direction of more political integration, maybe in a few years from now. But not now. Cyprus reminds us that the crisis is unfolding now and banking union cannot wait until 2014 or even longer.
So, the Euro Zone would need a banking union more urgently than ever after Cyprus, which in turn is a signal that the political will is too weak.
Exactly, and more specifically, the political will is lacking in Finland and Germany. They cannot have it both ways: making the monetary union work and moving away from the banking union – which they symbolically did by moving away from a common deposit insurance scheme. Suddenly we find ourselves in the situation, where other countries have a deposit guarantee up to 100’000€, but Cyprus has not. That is a step back from the banking union.
Are there any historic examples or precedents of a one-off tax on deposits in industrialised nations?
The article I wrote about this topic twenty years ago ended up being published in a book that was edited by none other than Mario Draghi. I looked at a number of such cases after World War I and again after World War II. In Italy in 1920, in Czechoslovakia in 1922 and in a variety of other cases, this kind of capital levies, taxes on wealth, is very hard to do for obvious reasons: the people do not like them, working class people do not like them any better than rich people do. There is always political resistance. It is always hard to do them in a clean fashion. I am not surprised that this is also the case in Cyprus now. The deposit levy will probably have to be modified before it gets the approval of the parliament.
What changes would have to be made?
What history shows is that this kind of levy is feasible only when two conditions are met: first, the problem of the country must be due to extraordinary circumstances beyond its own control, like in one of the World War. Secondly, the levy must be very progressive, so that it falls mainly on the rich, who can best afford the hit to their wealth, and not on those who can least afford the haircut and account for the majority of the electorate.
Are these two conditions met in Cyprus?
Clearly, the second one has not been met. The authorities made the mistake of applying the levy to the masses and not only to the wealthy. They made the mistake that it is not very progressive in the sense of applying a higher tax to the rich than to the poor − it is only slightly progressive. So the negative reaction now visible is mainly from the working class and some retirees. That suggests that it will be very difficult to get an agreement on this kind of levy, unless its structure is fundamentally changed.
And the first criteria?
Are the problems of Cyprus really due to extraordinary circumstances, for which the governments cannot be hold responsible, so that we can believe it will not happen again, ever? The answer is: not really. Of course, one of the reasons Cyprus is in this mess is that the Greek government had to restructure its debt, and that hit Cypriot banks. This was beyond Cyprus’ control, but it is not the fundamental problem.
What is the fundamental issue?
The Cypriot authorities allowed the banking system in Cyprus to grow very large. Cyprus became an off-shore money laundering centre – its authorities allowed that to happen. Therefore, I think the argument cannot be defended or maintained that the current problems reflect extraordinary circumstances rather than being a consequence of official politics. On both grounds, therefore, history suggests that this levy is not going to command widespread support, and it will be hard to push it through.
If the authorities amend the levy and make it more progressive, could it be established more easily?
What history shows is that you have to do other things at the same time to restore confidence. If the Cypriot authorities said: We made mistakes in the past, but now we are going to clean up our banking system, downsize the banks, stop doing business with the Russians and prevent these kind of problems from ever happening again – if they said that and started to do it, people would gain confidence that there would not be another levy in the future because there would not be more problems. Then the Cypriot deposits would come back, the situation would improve. So it really depends on whether the Cypriot authorities clean up their banking system and their economy. Then the impact would not be so negative and devastating.
Do you expect the authorities to act?
They apparently want to maintain the islands status as an off-shore financial centre attractive to the Russians. If they do that, people are going to believe that the same old problems will recur, and they are going to conclude that their deposits are not secure. That could be a big problem.
What could help investors to anticipate whether the authorities take steps in the right direction?
In Cyprus we need to look at whether they shrink their banking system, make it more transparent and stop doing business with Russian oligarchs. At the level of the EU and the Euro Zone we need more clarity about deposit guarantees, and whether they are sacrosanct or not, whether people with deposits under 100’000 € can feel confident about their safety. At the moment that is very much up in the air.
After the easing of the Euro crisis in recent months and with the problems in Cyprus now, how will the situation develop?
I am entirely confident that the Euro crisis is about to get worse – as I have said before this Cyprus event. The reason that it will get worse in Europe is the recession, undermining political support for reform. We have already seen that with the Italian election. Those problems will now deepen. The recession means that reformist parties loose support, extremist and populist parties gain support, and that creates high uncertainty about what will happen. In the future, the recession is clearly getting worse, the European Commission has revised its forecast, it believes now that there will be no growth in the second half of 2013. With the resumption of growth only in 2014, the markets and in particular the politics are not going to wait until then.
Has Cyprus worsened the situation in Europe significantly?
Cyprus is a reminder that EU officials are still confused, that their attempts to manage the crisis are inadequate, and that they are sending mixed signals. Even before, the ideas, that the crisis is receding, the patient is in remission and the underlying conditions have been addressed, were wrong. Again, the fundamental problem is that without growth there will not be continued support for reform. Once that becomes evident, and once there is a dispute over fiscal policy between France and Germany, or Italy and Germany, we will see the markets react negatively, and the crisis will be back with full force.
Is there no chance that the officials understand this message now?
I wish there was, but Cyprus is another reminder that officials are still in denial. What the commission said last week − we are flexible, we are giving France and other countries more time to bring their budgets into balance − will not be enough to get economic growth. The ECB still has not moved, there is not enough monetary support for growth. If EU officials are receiving the message, there is no sign of that in the policies they are pursuing.
This applies to the ECB as well?
The interest rates have not been reduced further, even though the ECB is underachieving its inflation target. Core inflation in the Euro Zone is a disastrously low 1.3%. It is a mystery why the central bank has not addressed this problem long since. One suspects that perhaps the ECB has taken criticism from Germany for the OMT bond buying program, and it does not want to do anything that would conceivably attract more criticism. But if that is an explanation, then the ECB is now part of the problem.