This is democracy in the European Union. Last week the Cypriot parliament voted down a proposal to secure the €10 billion funding needed to bail out its crippled banks that would have imposed a one off “solidarity levy” of 6.75% on bank deposits under €100,000 and 9.9% on those over. This week the Cypriots were offered the money in return for a deal which shuts the second biggest bank and scoops up €4.2 billion from uninsured deposits and moves the insured deposits (under €100,000) to the Bank of Cyprus where deposits over the €100,000 will be taxed at 40%. The Cypriot MPs, from Churchill to Quisling in seven days, accepted.
The counterproductive stupidity of the proposal has been widely noted. It’s difficult to see how the aim of shoring up Cypriot banks which have had their capital bases ravaged by haircuts on Greek government debt will be helped by a policy which is almost certain to cause a run on those very same banks.
But the strongest reaction was moral outrage that the Cypriot government, at the behest of the troika, was considering simply helping itself to its citizen’s cash. Personally I’m unclear how this is morally different to what governments do all the time. Indeed, in the age of the welfare state, big government, and redistributive tax and spending, it has become the governments raison d’être to do exactly this day in day out.
But we shouldn’t dismiss the idea so quickly. It stems from the notion that banks act as warehouses for deposits; that we go to the bank, make a deposit, and that that deposit sits there until we go back to the bank and take it out. Of course, under a fractional reserve banking system it doesn’t work like that at all. Just like the garage attendants who took Ferris Bueller’s Ferrari for a joyride round Chicago when he left it in their care, bankers lend multiples of our deposits straight out the back door as soon as we’ve taken them in the front door. In this sense, as Detlev Schlichter points out, deposits in banks are not like sticking your money in a safe; rather they are “loans to highly leveraged businesses”
You might say that no one actually thinks on that level when they deposit their money in a bank. Well, firstly, why wouldn’t they? The very fact that a bank pays interest on deposits (however small that might currently be) should be a warning sign that they are not merely humble warehouses. Ask yourself, how many warehouses pay you for the privilege of storing your stuff? They don’t because a warehouse has operating costs; it needs a building, it needs staff. It has to charge the people who leave stuff there, its depositors, a fee to cover these expenses.
A bank also has operating expenses; it too needs the buildings and the staff and much else besides. Yet, as the bank takes in your deposits and incurs these expenses, unlike the warehouse it pays you. It must, therefore, have another source of income, and it does; the yield on its assets, assets bought with your deposits. The bank is able to pay you interest because it is accumulating assets with your cash; the bankers are taking the Ferrari for a ride. That banks pay interest on deposits proves that they are not simply warehouses.
Secondly, are we sure that people don’t act like that? As a personal example, my old flatmate’s mum had money in Northern Rock and when it hit trouble she demanded a bailout. “Why did your mum put her money into Northern Rock?” I asked “Because they offered good interest rates” she replied.
Of course they did. That’s because their funding model, lending long term at typically higher interest rates with money borrowed short term at relatively lower interest rates was, ultimately, as risky as it sounds. Many Cypriot banks were offering rates of a relatively healthy 6% or more, but then they were investing 160% of Cyprus’ GDP in Greek government bonds.
One of the first things they teach you in GCSE Business Studies is that profit is the reward for risk. The high interest rates offered by Northern Rock and the Cypriot banks were indicators that they were engaged in something relatively risky. If you choose to take that risk on then I wish you all the best, but you should not expect a taxpayer bailout when things go sour to turn your investment into a one way bet; heads I win, tails I don’t lose.
The idea that governments must bail out busted banks is rarely questioned nowadays except by those who wish to be labelled some sort of economic ‘extremist’. In his book ‘How Capitalism Will Save Us’, free marketeer Steve Forbes has four index references to Joseph Schumpeter and 14 for creative destruction including one saying that “Washington should have let GM and Chrysler reorganise under existing bankruptcy laws”. Yet he answers the question of why the bailout of Detroit was wrong and that of Wall Street right by saying “The bailout was a necessary evil to avoid a collapse of the global economy”. Capitalism will not save banking, it seems.
But government bailouts of busted banks turn the investment that depositing is under fractional reserve banking into a no lose situation. This encourages risky investing and is how shaky banks become ‘too big to fail’. Goldman Sachs and JP Morgan were bailed out five times in the 20 years before 2008 so why wouldn’t they pile into subprime mortgage debt?
What is happening in Cyprus is undoubtedly a terrible situation for all involved. But if anyone is going to stump up for the bailout of Cypriot banks, isn’t it both fair and sensible that those who do are their investors?
When will someone establish a real bank, offering a warehouse service. The time must be right. Many people would pay a fee for it.
My old Uncle Ned used to put his money in a warehouse. It was a sock kept under his mattress. The fee he paid was the declining purchasing value of his savings thanks to inflation.
Perfectly sound arguments deployed in this article and the previous one by D.S.; same applies to the comments. Isn’t one thing being ignored though? If you were to ask a bank to “warehouse” your money, it would be fiat money you were sending them,and I doubt there would be many takers for the idea of paying them a fee to repay you on demand a currency with less purchasing power than that which you “deposited” other than over the very short term. Gold is a different matter and indeed one does pay warehousing fees for storing that.
That is the best way, but you are thinking like a rational logical man. This is not the mindset of a politician; and politicians get elected by what believe, not what is reality. In the UK and US those problems can be hidden through either taxation, or the problem can be inflated away. As long as the illusion can be maintained that the numbers on the base of your account summary haven’t changed (balance), but the money can be insidiously stolen, the game can continue.
Nearly all bad decisions that are taken, are perfectly politically understandable, whether that is wrong is here nor there.
*politicians get elected by what is believed, not what is reality
Very good article by John Phelan. I’d just add one point, namely that were anyone specifically wants near 100% safety (i.e. the “warehouse” option), banks should offer that service. Plus the money in those safe accounts could be lodged at the central bank and be given a government guarantee. Unlike existing accounts where that guarantee involves a seriously large taxpayer exposure, a government guarantee of the above safe accounts would involve virtually no taxpayer exposure because what is being insured is 99.9% safe anyway.
“[where] anyone specifically wants near 100% safety (i.e. the “warehouse” option), banks should offer that service”
If there were sufficient demand, they’d be offering it already.
Of course, there is already a ‘100%’ safety option for those who desire it: safe deposit boxes stuffed full of cash.
Re “if there were sufficient demand they’d be offering it already”, the reason they don’t is precisely that taxpayer funded deposit insurance enables commercial banks to offer near 100% safety combined with interest. In other words why put your money in a near 100% safe account which pays no interest if you can put it into a near 100% safe account which (thanks to taxpayers) does pay interest? Put it a third way, they ARE “offering it already”.
Plus there is National Savings and Investments which offers savings accounts which because they are government backed are near 100% safe. You can’t write a cheque or have a debt card based on those account, but you can withdraw money quickly and without notice. And about 20 million people have accounts at NSI.
“the reason they don’t is precisely that taxpayer funded deposit insurance enables commercial banks to offer near 100% safety combined with interest”
For balances up to the limit, I agree.
As I’ve noted previously, I’d prefer for deposit guarantees to be abolished (in an orderly way, so existing depositors have an opportunity to put their money somewhere safer).
With deposit insurance gone, people may well choose 100% reserve accounts. They’ll certainly think harder about where they put their money. I don’t think the government needs to make 100% reserves mandatory for demand deposits.
“Plus there is National Savings and Investments which offers savings accounts which because they are government backed are near 100% safe.”
Hadn’t heard of NS&I. Obviously I’d like to abolish that too
The only difference to letting the banks go bust and the Cyprus situation is that the Cyprus depositors have not lost all their money.
Having only lost 60 percent, who will be picking up the tab for the remaining 40 percent?
I really fail to see why the taxpayer should be considered as a backstop for rich depositors who should have known better.
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