Saturday, 30 March 2013

Cyprus, moral hazard and financial integration

Herbert Spencer: "The ultimate result of shielding man from the effects of folly is to people the world with fools"
Charles Kindleberger: "Such a view is understandable in a Darwinian age"
The possibility of extending the conditions of the Cyprus bail-out plan to other eurozone economies have increased uncertainty. The extinction of one of the two large Cypriote banks could have been anticipated. The tax on deposits above 100000 euro was unexpected.

Moral hazard

The rational for taxing uninsured depositors is that investors should bear the cost of the bail-out and not the tax-payers. If the policy authorities do proceed differently, say with a more traditional bail-out, the investors will feel protected and will continue to profit without bearing risk. It is again the moral hazard argument illustrated by the two introductory quotes: the reckless microeconomic behaviour of some investors cannot be insured by society. This reasoning is without question in our "Darwinian age". Nevertheless during the current crisis losses had to be absorbed by society to tame the macroeconomic consequences of some reckless investments. The reasoning is that society's  costs of inaction would in some cases exceed greatly the ex-post salvaging. This reasoning is also without question in our Social Welfare maximisation age. The only logical way to handle this trade off is to have skilled and knowledgeable policy makers supported by comprehensive, precise and timely analysis.


Let me go back to Cyprus. The narrative is that one or two banks (basically the financial sector) have engaged in a "casino" economic model: attracting external funds (read Russian, Uk, etc) offering high interest rates on deposits in a very favourable tax environment and engaging in reckless investments (read Greece). The casino appellation is important because it identifies a particular economic model, probably unique in the eurozone and suggests that the policy response of taxing uninsured deposits could only be extended to other casino models. No casino, no tax. I dismiss the suggestion to use in non casino economies similar measures without argument.

On the macroeconomic side, Cyprus behaves like a standard (very) small open economy in a currency area  with large current account deficits (they entered in 2008 in the euro, they are 865000 people and GDP is around 4.5 billion euro). They were hit by the crisis and when the flow of external funds suddenly stopped the economy stalled and the unemployment rate went to the roof (from 4 to 14 percent).

However when we look at the financing of the current account (the financial account) we see a massive and very rapid inflow of portfolio investment and "other investment" (a residual voice of the financial account which is not a residual because of size…). In the graph portfolioa_y is the stock of portfolio investment assets over gdp (while _l stands for liabilities, direct_y is net direct investment, iip_ is international investment position over gdp). Ex-post, this sudden inflow of short-term funds (true, a few quarters after the entry in the euro, but also simultaneously to Lehman brothers death) should have been contained. 

Policy makers might want to focus more on this huge and fast movement of capitals rather than on the size of the gross external positions. Gross external financial positions are a reflection of financial globalisation (see this older post) and are not a problem if they proceed at a "fundamental" pace (like in the other eurozone countries) and if we accept they cause greater interdependence. After all we read everyday that we live in Financial times.    

Sunday, 10 March 2013

Siamo Europei

A recent survey published by Il Corriere Della Sera shows that 74% of the electors favours the permanence of Italy in the eurozone. The error margin is said to be 3.5%. Notably the percentage of young electors that favours the euro is larger (you need to go to the website).