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Laurence J. Kotlikoff

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Cyprus -- The Nightmare Scenario

Posted: 03/24/2013 7:14 pm

Ralph Nader, America's great consumer advocate, used four words -- Unsafe at Any Speed -- to describe the Corvair, General Motor's death car of the 1960s. The Corvair's engine was placed in the middle of the car, which made it flip from a nice forward path to a crazy spin that would kill you if you hadn't said your prayers or were 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 so is every banking system around the globe, including our own. And when a 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.

But why should bank failures hurt the economy? Two reasons. First, the banks operate the financial highway system, connecting borrowers and lenders and savers and investors. When the banks fail it's like all gas stations going out of business. The public good -- the highway -- can't be used.

Second, bank failures change expectations. Everyone figures times are bad and take the individually optimal actions needed to assure that collective terrible outcome. Economists call this a coordination failure, but I like sociologist Robert Merton's way of putting it, namely a very nasty self-fulfilling prophecy.

The Cypriot banks did what all banks do. They gambled. They borrowed money by taking in deposits as well as selling bonds, promised to repay, and then invested in assets they were sure would pay off. These assets included lots and lots of Greek government bonds.

The Greek tragedy that befell Greece and its bonds has, thus, now become a Cypriot bank tragedy. Having borrowed roughly eight time Cyprus' GDP, much of it from Russian companies and nationals, the Cypriot banks are bust, bankrupt, belly up and in no position to make good on their pledge to depositors that they could get their money back on demand. Indeed, Cypriot bank demand deposits are frozen as the Cypriot government decides what to do.

Unfortunately, it's three options are a rock, a hard place, and another rock. The first is reversing its decision of a couple days back and accepting the IMF/EU conditions for a bailout, namely imposing a 9.9 percent haircut on deposits over €100,000 and a 6.75 percent haircut on smaller deposits. The Russians hate this and the public hates it even more. The second is telling the IMF/EU to get lost, reopening the banks, and watching crazed depositors rush to get whatever money they can out of the banks on a first-come, first-serve basis. The third is going off the euro and declaring that all deposits will be paid off in new Cypriot pounds, which the government will simply print out of thin air.

Whatever happens, no one is going to trust or use Cypriot banks. This will shut down the country's financial highway and flip Cyprus' economy to a truly awful equilibrium in a replay of our own country's Great Depression, which was kicked off by the failure of one-in-three U.S. banks.

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, they may 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. Every bank in each of these countries has made promises they can't keep were push come to shove, i.e., if all depositors demand their money back immediately.

We've seen this movie before. And not just in real life. Every Christmas television networks play It's a Wonderful Life in which banker Jimmy Stewart barely saves his small town from economic ruin arising from a banking panic.

But 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 "hard" money and give it to the banks to use to pay off depositors. But the specter of this massive money creation, which in the U.S. case would entail printing roughly $12 trillion overnight, would spark fears of inflation. The fear of inflation would, 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's built to collapse with the right triggering events?

Perhaps we tolerate ongoing financial and economic fragility because we don't see a safer way to run our banking system. There is, in fact, a much safer way. It's called Limited Purpose Banking, which I proposed in my book Jimmy Stewart Is Dead. The plan, detailed here, has been endorsed by a Who's Who of leading economists and policymakers, including six Nobel Laureates, 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. 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 -- market 100 percent equity-financed mutual funds. Such mutual funds take in money, not by borrowing, but by selling shares of stock. They then invest this money in the securities in which they specialize. Equity financed mutual funds are, thus, small banks with zero leverage (debt). And a bank that has no debt can never fail.

To eliminate opacity and ensure that people know what they are buying when they buy mutual fund shares, 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 (This doesn't include the money market funds that effectively leveraged.) sailed unscathed through the great crash of 2008. Their investors lost money. 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 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. It's time to switch to Limited Purpose Banking.

 

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