What is it about the islands around Europe's periphery?
Is there some peculiar psychological thing about proximity plus the illusion of isolation that makes them turn themselves into havens for runaway banks? Inquiring minds want to know.
Anyway, Cyprus's story has obvious parallels with both Iceland's and Ireland's, with R.M.M.L. — Russian mobster money laundering — as an extra ingredient. All three island nations had a run of rapid growth as their status as banking havens left them with banking systems that were too big to save. Iceland, at peak, had banks with assets that equaled 980 percent of gross domestic product; Ireland was at 440 percent. Cyprus, at around 800 percent, was closer to Iceland in this respect.
In all three instances, runaway banking was the source of the crisis — although not everyone seems to get this, even now. In any case, the question is what to do about it.
Iceland got through the crisis with less damage than Ireland, for two reasons. First, it let its banks default on liabilities to overseas creditors, including deposits in offshore accounts. Second, it had the flexibility that comes from having your own currency.
Iceland's currency advantage helped the real adjustment of the economy; it also allowed some fairly undisruptive financial repression, because the depreciation of the krona (coupled with temporary capital controls) led to a brief burst of inflation that eroded the real value of deposits. Savers were hurt — but with banks having grown to 10 times the G.D.P., that was going to happen one way or another.
Cyprus, unfortunately, seems to be making a hash of it. To be fair, the proposed levy on depositors was actually smaller than the real losses Icelandic depositors took (and they lost on their currency holdings too). But this is just the beginning! Even with the effective default on deposits, Cyprus will need a huge loan from the troika — the European Central Bank, the European Commission and the International Monetary Fund — and the condition for this loan will be harsh austerity. This looks like the beginning of endless, inconceivable pain.
The Russians Are Coming!
The Russians Are Coming!
How big a deal is the Russian factor in Cyprus's crisis? Pretty big, it seems. Over at the Financial Times, the financial blogger Izabella Kaminska reported on some estimates indicating that 19 billion euros in Russian nationals' deposits are in Cyprus banks, which is more than the country's G.D.P. While I'm not expert in this area, I wonder whether this is an understatement; given what we think we know about the nature of much of this Russian money, is all of it really being declared as Russian?
Let me make a broader point: We've now seen three island nations around Europe become huge international banking hubs relative to their G.D.P.'s, then get into crisis because their domestic economies don't have the resources to bail out those metastasized banking systems if something goes wrong. This strongly suggests, to me at least, that we have a fundamental problem with the whole architecture (to use the preferred fancy word) of international finance.
As long as you haven't bought into the Barney-Frank-did-it school of thought, you realize that the global crisis of 2008 was in a fundamental sense made possible by the erosion of effective bank regulation. As the economist Gary Gorton has documented, there was a 70-year "quiet period" after the Great Depression in which advanced countries had very few major financial flare-ups; Mr. Gorton argues, and most of us agree, that the key to this quietness was a constrained, regulated financial system that also limited the opportunities for excessive nonbank leverage.
But this regulation in turn depended, to an important extent, on limited international capital flows; otherwise regulations made in Washington or elsewhere would have been bypassed via havens like, well, Cyprus. And once those capital controls began to be lifted in the 1970s we entered an era of ever-bigger financial crises, starting in Latin America, then moving to Asia, and finally striking the whole world.
So what are we going to do about this? Cyprus, as a euro-zone country, should really be part of a euro-wide safety net buttressed by appropriate regulation; it's insane to imagine that the euro can be run indefinitely and merely with national deposit insurance. But euro-area deposit insurance doesn't seem to be in the cards — and anyway, there are plenty of other potential Cypruses out there.
All of which raises the question: Is the era of free capital movement just a bubble, fated to end one of these years, maybe soon?