Revisiting Cyprus

The big topic in this class 2 years ago was the financial crisis in Cyprus. It's time to revisit how the Europeans addressed this issue, and how that's worked out.

First, a primer. The crisis in Cyprus was different from my coverage of Greece II this year, or Greece I whenever the last time was that I had to explain Greece to you folks. Over the previous decade, Cyprus had rapidly evolved into an offshore banking center for Russians, who deposited wealth that was often ill-gotten (proximity, warm water, and nice beaches all help). At the same time, it was admitted to the EU in 2004, and the EMU in 2009 (so the Russians were getting their money out of Russia and into the EMU). Those deposits needed to be invested somewhere, and Cypriot banks invested a lot of them in ... get this ... bonds issued by the government of Greece. When those went south, Cypriot banks became insolvent. But the EMU has organizational problems: all those deposits were now in euros which could move freely within the EMU, but the Cypriot government was responsible for being the lender of last resort for its own banking system. And they couldn't raise the money. So they went begging to the troika, and they weren't that happy to be providing deposit insurance to ... mostly Russian oligarchs. So they demanded a bail-in: in the final agreement depositors were required to contribute part of their deposits back to the banks to reestablish their capital. Basically, large depositors were told that to avoid the banks shutting down (and depositors losing everything), that half of their deposits would be forfeited, and the other half of their deposits would be replaced with shares of stock in the bank (whose value quickly fell to almost nothing) that was able to stay open due to the cash infusion. Pictures are a lot easier right: here's what a bail-in really means.

So, how'd that work out for Cyprus?

Well, the unemployment rate in Cyprus (that was in the 4-6% range for most of the oughties) climbed up to about 16% and has plateaued there.

One thing we've learned, again, is that despite economists dislike* of the political solution of capital controls ... they seem to work OK. And after 2 years, the capital controls are set to be lifted soon. If money doesn't start pouring out of the country again, then Cyprus is probably good to go. But here's a picture of what a capital control looks like.†

And, Cyprus has worked to rationalize some of its financial laws with how things are done in other countries. In particular, they're working on giving banks better recourse for dealing with non-performing loans.

But the Cypriots themselves are ticked off at the rest of the Europeans: they feel they didn't get the help they needed when they needed it, and are still paying for the trouble.

* Why do economists dislike capital controls? It's the whole voluntary exchange thing: if consumers want to move their wealth out of someplace, that's a form of free trade that probably should be permitted. Why do politicians like capital controls? Well ... hmm ... because they get blamed for financial crises, and sometimes those end with politicians getting killed.

† What specifically do capital controls mean? Pretty much no acceptance of "checks or debit cards, your checking account is now a savings account from which you can make limited daily withdrawals, your savings accounts is now a CD, your existing short-term CDs will be automatically rolled over into long-term CDs, and you can’t cash them out early."