03/22/2013 06:31 pm ET | Updated May 22, 2013

Liquidity vs. Stupidity: Two Early Lessons From Cyprus

If Chairman Mao said, after two centuries, that it was still too soon to judge the impact of the French revolution, it's probably a bit premature to learn much from the ongoing Cyprus bank debacle. That said, we at OTE are obliged to briefly speculate:

#1: OK, I'm gonna go out on a limb on this one, and assure you that we don't need a lot of time to transpire to learn this lesson: unless you're trying to start a bank run, don't spring a tax on bank depositors. As I've always stressed, the problems in the Eurozone are deep and not amenable to simple solutions, so I'm willing to be told I'm missing something important. But didn't someone around the table in Brussels raise their hand and say, "Hey, wait a sec... do we really want to levy this tax on a banking system that's already teetering?"

#2: The above is obvious. This one, less so, but it's a lot more important: Large imbalances often lead to underpriced risk, over-leverage, and systems' failure (default, near-default, long recessions with over-corrections (Minsky moments). The Cypriot case looks like one where a lot of offshore money, some allegedly hot from Russia, found its way to a tiny nation selling international banking services. Some reports suggest the banking sector grew to seven times GDP, though Yves Smith tells a more nuanced story with convincing data here. But the lesson still holds.

Banks, commercial or otherwise (I-banks, S&Ls, mortgage lenders), don't make money by sitting on it. They must lend. And when they're experiencing large inflows, whether from Asian investors in the U.S. housing boom or Russian gangstas, they go shopping for places to amplify those flows.

That's finance -- there's nothing wrong with it (except maybe the gangsta part). To the contrary, the text book case is that these excess savings find their way to the most productive uses and the virtuous cycle is off and running. But the real world case looks a lot different.

In the U.S. and some parts of the European meltdown, sloppy underwriting and "innovative" finance plowed the excesses into a massive housing bubble that lost trillions and from which we're only now recovering (while much of Europe remains mired). Greece over-leveraged on imbalanced surpluses from northern Europe with no fiscal structures in place to finance its debts, and Cyprus invested in Greece.

Again, I'm grossly simplifying and more time must pass before these autopsies reveal their real lessons, but I suspect once they do they will show the following: capitalism in this era ran amok in no small part because policy makers accepted the teachings of the high-priests of economics that modern economies self correct. They work out their excesses and imbalances without state intervention, oversight, or regulation. Those functions, the priests said, would only cuff the free hand.

I'd like to think that we now know that the free hand, uncuffed, is often all thumbs. I'd like to think that our policy makers are interested in systems that identify the types of destabilizing imbalances from which we've suffered in recent years. That's what I'd like. I doubt it's what I'll get.