~ Frederic Sautet ~

Some depositors at Cyprus’ largest bank may lose a lot of money (e.g. see article in FT). Those with deposits above €100,000 could lose 37.5 percent in tax (cash converted into bank shares), and on top of that another 22.5 percent to replenish the bank’s reserves (a “special fund”). Basically “big depositors” are “asked” to pay for (at least part of) Cyprus’ bailout (the rest will be paid by other taxpayers in the EU).

I cannot think of a faster way to completely destroy a banking system than to expropriate its depositors. This is the kind of policies one would expect from a banana republic, not from a political system that rests on the rule of law. But this is the point: the EU does not respect the principles upon which a free society is based. The more a government uses the tools of expropriation, the more it creates the conditions of its future demise. Big depositors will not come back to Cyprus once all this is over. And restricting capital flows, as it is the case now, worsens the situation in the long run.

As many commentators have said, the Cyprus problem, like that of Italy, France, Greece, Portugal, and Spain is one of public finance. As the EU moved from a free trade zone to a political system after the ratification of the Maastricht Treaty in 1992, it also (among many other things) progressively collectivized the risks associated with public spending. Until the euro came along, countries with bad public policies would simply devaluate their currencies. The French government, for instance, devaluated the franc twice (in 1981 and 1982) under Mitterrand’s presidency and in 1983 the Deutsche mark and the florin were reevaluated against all the other European currencies. Under this system the consequences of bad public policies are internalized to a large extent. The euro changed that. Bad policies are now either kept in check at the country level because no currency devaluation is possible (that’s the positive scenario), or the consequences of bad policies are born by the entire system. This, of course, is only if EU authorities want to keep the euro zone intact, otherwise they could simply let Greece and Cyprus out of the euro zone, but this would be to admit the failure of their grandiose currency plan. This is why the European Central Bank is resorting to Stalinist methods to make sure the government in Cyprus does what the EU wants it to do.

Now that EU governments have decided to collectivize the risks attached to public spending, it’s hard to see what will stop the next crisis from happening. The EU had already become a system of redistribution from rich to poor (e.g. the CAP), now everyone knows that it is a system of collectivization of the risks attached to public spending, deficit, and debt. The risk attached to Cyprus bonds are now collectivized; they are not just Cyprus’ problem. Unless the fundamental principles upon which the EU rests change, it will eventually collapse as collectivized risks are probably too big an incentive for many countries in the EU (principally the FIGS countries: France, Italy, Greece, and Spain and the PIGS: Portugal, etc. I can’t find an acronym that would work for all five of them…).

The EU today is a case in point of “market-destroying” federalism. As Barry Weingast pointed out in a series of great papers on federalism (The Economic Role of Political Institutions, Federalism as a Commitment to Preserving Market Incentives), the institutions of federalism lead to political competition and the weeding out of bad policies (it is “market preserving”). But if this mechanism is attenuated through transfers from the federal state to lower jurisdictions, the incentives to maintain one’s fiscal house in order disappear. Ultimately the entire system collapses as a result of collectivized risks. This has been slowly happening in the United States throughout the 20th century, but it is taking place at an even bigger level in the EU because the EU is a hybrid federal system. This is why many want to centralize political and policy powers in the EU so as to make the place more like the US (a European banking union would be a first step in that direction according to the defenders of greater centralization).

It is likely, however, that greater centralization would fail because at the end of the day, EU institutions are not geared towards market-preserving federalism. The dominant thinking is one of indicative planning, regulation, and neo-mercantilism. In my opinion, the only course of action to save the EU would be to return to the original free-trade zone agreement of the 1950s and 60s. Trade zones enable political competition, which leads to virtuous outcomes such as lower taxes and lower public spending. Moreover, free trade zones with freely competing currencies, even if they remain government produced (one could adopt the Deutsche mark anywhere in the zone for instance), would bring vast positive benefits to Europeans. This would imply a complete reversal of policies, which shows how far we are from solving the problems in Europe. Ultimately, of course, governments should get out of money production, but that’s maybe for another century.

ADDENDUM (4/3): for a much more acurate analysis of the monetary and banking situation, read Jerry O'Driscoll's excellent post on Cyprus in ThinkMarkets.