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Cyprus: The Nightmare Scenario and How to Avoid It in America

Customers queue to withdraw cash from an automated teller machine (ATM) outside a Cyprus Popular Bank Pcl, also known as Laiki Bank on Thursday, March 21. The European Central Bank said it may cut Cypriot banks off from emergency funds after March 25 as the island nation’s president, Nicos Anastasiades, scrambled to forge agreement on a plan to stave off financial collapse. Photo by Simon Dawson/Bloomberg via Getty Images.

A Note from Paul Solman: Tiny Cyprus is tottering. Small Greece is quaking next door. Will the other larger borrowers of Southern Europe be next? And after that?

Our Social Security expert for PBS NewsHour’s Business Desk, noted Boston University economist Larry Kotlikoff, likens what’s happening now to the day he himself nearly died, years ago, when the technology he was banking on suddenly failed him. His fears and his prescription are Thursday’s Business Desk post.

Larry Kotlikoff: Ralph Nader, America’s great consumer advocate, used four words — Unsafe at Any Speed — to describe the Corvair, General Motors’ death car of the 1960s. The Corvair’s engine was placed right in the middle of the automobile, which made it flip from a nice forward path to a crazy spin that would kill you if you hadn’t said your prayers properly or were just damn lucky.

I was lucky, damn lucky, one rainy evening in 1969. I was driving my dad’s Corvair, doing 65 on a major highway during rush hour. All was calm and serene when suddenly the car tried to kill me, sending itself into a wild 180-degree spin, which miraculously hit nothing. It was precisely in those few seconds that Unsafe at Any Speed burned into my cerebellum.

Nader’s words came back to me in 2008 as I, like you, watched the global banking system collapse, which ushered in The Great Recession, from which the developed world is still reeling.

And his words returned to me in the last few days as I read about Cyprus’ banking crisis. Like the Corvair, the banking system in Cyprus is built to fail – to spin out of control at a moment’s notice. But Cyprus has barely a million people. What’s so scary is that every banking system around, including our own, is vulnerable in the same way. And when any country’s banking system fails, its economy flips from a good path to a bad one — in economics-speak, from a good to a bad equilibrium. Given the interconnectedness of the world banking system, unsafe at any speed is a recipe for another 2008 — or worse.

Why should bank failures hurt the economy? Two reasons. First, banks operate a country’s financial highway system, connecting borrowers and lenders to savers and investors. When the banks fail, it’s as if all the gas stations in the country go out of business — simultaneously. And then the public good — the highway system — can’t be used.

Second, bank failures change expectations. Everyone figures times are bad and about to get worse. They take actions — like hoarding resources — for the terrible times that might come. But such actions, while optimal for each individual, add up to a collectively terrible outcome. Bare shelves. Empty ATMs. Bank runs. Paralysis. Economists call this a coordination failure, but I like the late sociologist Robert Merton’s way of putting it: a very nasty self-fulfilling prophecy.

What Happened in Cyprus

The Cypriot banks did what all banks do. They gambled. They borrowed money by taking in deposits, borrowed money by selling bonds. They swore to pay back all the money, plus interest, on the deposits and bonds. Then they took the money and loaned it out, at a somewhat higher rate of interest, to businesses and individuals who figured to pay it back. These loans were the banks’ assets. The difference between the interest they charged their borrowers and the interest they paid to depositors and bondholders was used to run the banks, pay CEO bonuses, and cover bad loans. Whatever remained was profit.

The problem in Cyprus is simple: the banks’ assets included, in large part, government bonds from nearby Greece.

The Greek tragedy that befell Greece and its bonds has thus become a Cypriot bank tragedy. Having borrowed roughly eight times Cyprus’ GDP from depositors and bondholders, much of them allegedly insalubrious Russian companies and nationals, the Cypriot banks are now bust, bankrupt, belly up, and in no position to make good on their pledge to their lenders — especially the depositors, to whom they promised, as banks do, to pay the money on demand. Indeed, Cypriot bank demand deposits are frozen at least through next Tuesday as the Cypriot government decides what to do.

Unfortunately, the small country’s three options are: a rock, a hard place, and another rock. The first option is to reverse a decision of a couple days back and accepting the International Monetary Fund/European Union conditions for a bailout, namely, imposing a 9.9 percent haircut (a one-time tax) on deposits over €100,000 and a 6.75 percent haircut on smaller deposits. The Russians hate this and the non-Russian Cypriot public, which also has bank deposits, may hate it even more. The second option is telling the IMF/EU to get lost, reopen the banks, and watch crazed depositors rush to pull whatever remaining money they can out of the banks on a first-come, first-served, get-the-hell-out-of-my-way basis. That’s what had begun to happen in Cyprus before a bank “holiday” was declared. The third option is going off the euro and declaring that all deposits will be paid off in new Cypriot pounds, which the government will print for the occasion.

Whatever happens, no one is going to trust or use Cypriot banks for quite some time. This will shut down the country’s financial highway and flip Cyprus’ economy to a truly awful equilibrium — a replay of our own country’s Great Depression, perhaps, which was fueled, if not kicked off, by the failure of one in three U.S. banks. That, of course, was also the fear worldwide in 2008.

Cyprus is a small country. Still, the failure of its banks could trigger massive bank runs in Greece. After all, if the European Central Bank is abandoning Cypriot depositors, might they not abandon Greek depositors next? A run on Greek banks could then spread to Portugal, Ireland, Spain, and Italy and from there to Belgium and France and, you get the picture, to other countries around the globe, including, drum roll, the U.S. 2008 all over again. Every bank in each of these countries has made promises they can’t keep if all depositors demand their money back immediately.

Jimmy Stewart is Dead

We’ve seen this movie before. And not just in real life. Every Christmas, our televisions show It’s a Wonderful Life in which small town banker Jimmy Stewart barely saves “Bedford Falls” from economic ruin by stopping a banking panic through the force of reason and good will.

But, you might ask, could little Cyprus, figuratively speaking, be the thin sheen of water that flipped my Corvair from a fun buggy into a death trap? Could it really kick off a global banking panic? Yes. The chances are small. But even a very small chance of an enormous collapse can spell a huge expected problem.

Yes, the Federal Reserve, European Central Bank, Bank of England and other central banks can print so-called “hard” money and give it to the banks to pay off depositors. But the specter of such massive money creation would spark fears of massive inflation, since, in the U.S. case alone, providing enough to pay off all depositors would entail printing as much as $12 trillion overnight were bank runs to happen here. The fear of inflation or “hyperinflation” might, in turn, prompt everyone to get and spend their money as fast as possible before prices rise. This transformation of money into a hot potato would, by itself, produce the inflation that everyone would fear.

Given the above, the question we need to ask about Cyprus is not really about Cyprus. The question we need to ask is why we continue to tolerate a banking system that is built to collapse at the first sign of true alarm?

Perhaps we tolerate ongoing financial and economic fragility because we don’t see a safer way to run our banking system. But there is, I believe, a much safer way. It’s called “Limited Purpose Banking,” which I proposed in my book Jimmy Stewart Is Dead. The plan, which I explained on this page in video a while ago is detailed here. Thoroughly non-partisan, it has since been endorsed by a Who’s Who of leading economists and policymakers of all stripes, including six Nobel Laureate economists, former Treasury Secretary George Shultz, former U.S. Senator Bill Bradley, and former Labor Secretary Robert Reich.

Limited Purpose Banking (LPB) eliminates the two key factors that make traditional banking so fragile. The first is leverage (how much the banks borrow in order to lend). The second is opacity (the banks don’t tell us what they are doing with our money).

LPB eliminates leverage by forcing all financial corporations to operate as mutual fund holding companies that do one thing only — give depositors 100 percent mutual funds. Such mutual funds take in money, not by borrowing, but by selling shares. They then invest this money in the securities in which they specialize. These mutual funds are, thus, small banks with zero leverage (debt). A bank that has no debt can never fail.

To eliminate opacity and ensure that people know what they are buying when they buy the shares of any given mutual fund, a new federal agency — the Federal Financial Authority (FFA) — would verify and disclose all securities held by the mutual funds. The FFA would do for the financial services industry what the FDA does for the drug industry — ensure its products aren’t arsenic parading as a cure-all.

Mutual fund banking is not new. Most of us have our 401(k)s or IRAs invested in mutual funds. Indeed, there are more mutual funds in the U.S. than there are banks. The ones that were equity financed — that is, they got all their money without borrowing any — sailed unscathed through the great crash of 2008. The ones that were leveraged, like money market funds, did not. Yes, all mutual fund investors lost money if their shares went down in value. But the funds themselves — their part of the financial highway system — never failed.

Those who don’t learn from history repeat its mistakes. The lesson from Cyprus is the same one we should draw from the long history of banking crises and the terrible economic fallout they engender. The lesson is simple. Traditional banking is unsafe at any speed. I’ve been saying it for years: It’s time to switch to Limited Purpose Banking.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions

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