Why We All Have to Worry about Cyprus

Why We All Have to Worry about Cyprus

March 27, 2013

With Europe’s brazen mismanagement this week of the banking collapse in Cyprus, the Euro crisis moved closer to farce and, potentially, closer to a serious problem for the rest of us. Over the past three years, as global investors have periodically fled the government bond markets of Greece, Portugal, Ireland, Spain and Italy, Eurozone leaders have grudgingly spent $650 billion bailing those countries out. The whole point of these bailouts has been to protect the solvency of the European banks that hold most of the bonds of those countries, including any of the leading banks in Germany and France. Yet, last week, when the two major banks in tiny Cyprus needed a modest bailout of $13 billion to hold the Eurozone together, European leaders proposed that all of the banks’ depositors help pay the bill. In short, they were prepared to tear up the EU pledge of deposit insurance, the last defense against nationwide bank runs.

Luckily, the people of Cyprus said no. Yet, this Tuesday, Eurozone finance ministers came up with a new way of restructuring the ailing Cypriot banks that will still mean large losses for their large depositors, as a condition of the latest bailout. So now, the next time global investors lose confidence in the bonds of, say, Italy or Spain, the banks across Europe that hold those bonds may face waves of withdrawals by their largest depositors. That could bring on the kind of far-reaching financial crisis which the bailouts were designed to head off.

From the vantage of Berlin or Paris, the new deal is certainly appealing in broad, if crude, political terms. European voters get the satisfaction of forcing the well-heeled depositors of the failing banks to pay a price, along with those banks’ investors. And many of those depositors aren’t even Eurozone citizens: Instead, they’re hyper-rich Russians, including at least 80 oligarchs who looted much of their country’s economy and then shifted their proceeds to foreign accounts. They didn’t choose Cypriot banks for their investment expertise, since the bankers sunk much of the deposits in Greek sovereign bonds, the world’s worst investment. They chose Cyprus because it’s a traditional tax haven with very low taxes and strict bank secrecy laws. Old times may also have played a role with many of the oligarchs, since Cyprus was once the KGB’s favorite listening post on the Middle East.

The global economics of the deal, however, are simply terrible. Large depositors account for a tiny fraction of all Cypriot bank accounts, but more than half of all Cypriot bank deposits. It’s a pattern seen almost everywhere, including the United States. Here, bank accounts of $250,000 or more account for less than one-half of one percent of all bank accounts, but nearly one-quarter of total bank deposits. In normal times, our own deposit insurance limits the amount subject to its guarantee at $250,000. But when confidence in banks is fragile or failing, the government always steps in to guarantee all deposits. That’s just what the Treasury and FDIC did in September 2008, to prevent a run on American banks by large depositors that would have spread the crisis across the U.S. banking system. That unlimited guarantee remained in place until our financial system was stable and healthy again, ending only at the end of last year.

Eurozone leaders have ignored these basic tenets of deposit insurance. Instead, they have sent a troubling message to large European depositors: Even in a financial crisis, large accounts are no longer safe. So, the next time that global investors begin selling off Italian or Spanish government bonds, threatening the solvency of the banks holding those bonds, we could see a run by large depositors not only in Italy and Spain, but also across Germany and France. And that would set off a new financial crisis that could trigger a downward spiral across much of world – including here in America.

Moreover, it seems that unnecessary economic mistakes have become the new norm. Austerity programs for economies struggling with weak recoveries, both here and across much of Europe, are the most common example. That’s why the Eurozone, taken together, has been in a recession for nine months; why Britain’s GDP has declined in four of the last five quarters; and why even the German economy has been contracting since at least last October. And an extended downturn in Europe only increases the likelihood of renewed government bond problems in Italy or Spain which, given this mismanagement of deposit insurance in Cyprus, could spiral out of control.

These are not the only examples of inane economic policy thinking these days.

Paul Krugman this week, for example, offered a defense of capital controls, citing how the movement of funds in and out of national markets can destabilize economies. But the issue is not the unfettered movement of funds across global markets. In fact, those capital flows have been a key factor in the strong performance of many developing economies, as well as our own economic stability. Rather, the problem lies in what financial institutions do with those funds and the willingness of governments to enforce sensible limits on what they do. In the end, the spectacular stupidity of Eurozone leaders this week may be just the most recent and dangerous example of how politicians manage to miss the most obvious and important economic point.



How a Grand Bargain on the Deficit Could Erode Social Security

March 13, 2013

Paul Ryan’s new budget blueprint released this week — details to follow, as usual — will only intensify the partisan warfare over the deficit. In truth, the deficit is just a cover story here, since the real debate is over the scope and role of government itself. Ryan at least is more upfront about it than most – he includes large new tax cuts as well as draconian spending reductions in what is ostensibly a plan to “balance the budget.”  In his fervor to miniaturize Washington’s domestic role, however, he cannot provide the resources to maintain the core commitments of Social Security and Medicare.

The ideological core of this debate also explains why most of the proposals and agreements of the past year have paid so little heed to the needs of the economy. There is no doubt that the spending cuts and tax hikes of the last six months have weakened economic growth — and as a result, deficits actually could be larger over the longer-term than they otherwise would have been. The additional spending cuts contemplated for the next six months under the sequester — and under most of the grand bargains being floated to supersede the sequester — would inflict more damage. In this regard, Ryan stands at the extreme with a plan that would drive us back into recession.

Nonetheless, a major deal that includes entitlement reforms and tax-loophole closings remains possible. In the politics that could determine the relative weights of those two factors, Republicans will have less maneuvering room on taxes than Democrats will enjoy on entitlements. That’s because primary challengers from the far right already have taken down a number of conventional Republicans, heightening the GOP’s resistance to more revenues. By contrast, there have been no successful attacks so far on centrist Democrats for supporting the cutbacks in federal programs now in place. This political difference suggests that more of the burden in any grand bargain will likely fall on entitlements than on revenues. The next question is, what entitlement changes could Democrats accept and still preserve the essential missions of those programs.

Let’s consider Social Security and its core guarantee of basic economic security for more than 40 million retirees (plus nearly 9 million people with disabilities). Unfortunately for Ryan and his fellow supporters of austerity for the elderly and disabled, no change that would trim the benefits of all Social Security recipients is compatible with the program’s central mission. To begin, while countries such as Germany, France and Italy provide monthly pension checks equal on average to 75 percent or more of a person’s average monthly wages over a lifetime, this “replacement rate” for Social Security is only about 40 percent. That translates into an average monthly benefit of $1,230, or less than $15,000 per-year. Moreover, these bare benefits comprise at least 90 percent of the total income for more than one-third of all current Social Security recipients.

Let’s do the math. The terms just described translate into an annual income of less than $16,300, which amounts to a very bare minimum. After all, the average cost today of a small apartment (rent and utilities) is over $7,000 per-year. Even if elderly people pay 20 percent less than the average, their rent and utilities still claim an average of $5,600 per-year or nearly 40 percent of all their income. Add to that at least $335 per-month for food at a poverty level ($4,000 annually) and another $310 per-month for Medicare Part B and Part D premiums and other out-of-pocket medical expenses ($3,700 annually). That leaves tens of millions of elderly and disabled Americans with about $130 per-month ($1,600 per-year) to cover all other expenses such as clothes, transportation, recreation, state and local taxes, and any unexpected expenditures.

These data suggest that any across-the-board benefit cut today is incompatible with Social Security’s essential mission. That takes off-the-table changes in the annual inflation adjustment or the retirement age. Given current benefits, the only reforms consistent with the program’s central commitment are ones based on means-testing. For example, Congress could apply a smaller annual cost-of-living adjustment to the benefits of the top tier of retirees. And if Congress is set on guaranteeing the system’s solvency for the next 75 years, in the same spirit they should think about applying the payroll tax to the capital income of the top tier of workers. Not that there is an enormous rush, given the actuaries estimate that the system’s solvency is secure for at least another quarter-century.

Much like George W. Bush’s proposal to privatize part of Social Security, the 2013 Ryan budget is simply uninterested in the missions that animate federal entitlement programs. Democrats would commit a grave mistake, as a matter of both social policy and politics, if they also sacrificed those commitments in search of Republican acquiescence to more revenues.