Lessons From Cyprus

The troubles in Cyprus may seem remote to many investors, and involve a small nation whose economy is not terribly influential to many businesses in other parts of the world, but the events unfolding there should be clearly understood by all participants in the "modern economy," no matter the level in which they participate in said economy.

The banking crisis in Cyprus provides a crystal-clear lens through which to examine some of the fundamental issues facing anyone forced to use fiat currency to obtain the goods and services they need to survive (which is to say, just about anyone reading this article).  Fiat currency means currency which is mandated by government decree (by "fiat," from the Latin verb meaning "Let there be," as in fiat lux: "Let there be light").  

Other forms of money have existed before fiat money -- forms of money which communities settled on to enable easier exchange of goods and services and to store value, whether in the form of pieces of gold or gigantic round stones with holes through their centers.  Because fiat systems are forced on the people by government dictate, and because that government then controls the supply of the money in a fiat system, the people participating in a fiat system are at the mercy of those controlling the supply of that money.

Most people know that the situation in Cyprus involves people standing in long lines at ATMs, hoping to withdraw money which they loaned to their banks, and that the banks are currently closed so that depositors cannot withdraw more money.  The reason that the banks are not allowing people to get their money back is that the banks are insolvent, and in most modern countries when banks become insolvent the government steps in to make sure that people can get their money back.  The problem in Cyprus stems from the fact that the government of Cyprus does not have the wherewithal to back up the banks (one troubled bank in particular, in this case).

Thus, the government of the Republic of Cyprus needed to turn elsewhere for help, first turning to Russia and then, as time dragged on and the government was unable to increase its income enough to meet its obligations, leading to a precipitous downgrade in its credit rating, Cyprus became a pariah whose debt  (bonds) could no longer be held in most investment funds, and its government had to turn to the European Financial Stability Facility for an emergency loan of ten billion euros.

Earlier this week, a loan was approved, after the initial proposed terms were rejected by the parliament of Cyprus.  Part of the stipulations of the final loan of ten billion euros from the International Monetary Fund included the "levying" (that is to say, "taking") of all the uninsured deposits at the failing bank, as well as the levying of 40% of all the uninsured deposits everywhere else on the island.  Uninsured deposits, in this case, means deposits of more than a hundred thousand euros (there is no explicit deposit insurance in eurozone banks, the way there is in the US, but there is an implicit assurance that deposits up to a hundred thousand euros are backed by the government; in the US, deposits are insured by the FDIC up to $250,000).

The idea that bank deposits could be seized by the government as part of the terms of a loan that government enters into because it is in dire financial straits itself obviously raises all kinds of emotional responses in those watching this crisis unfold, and the assurances that "most of" the big deposits are probably owned by shady characters from Russia (according to the press) does not change things.  After all, should honest depositors who have a lot of money see their funds levied just because other large depositors were involved in criminal activities?  Isn't that the same as punishing all the kids on the playground for the bad actions of a few of them*?

What observers of this train wreck need to understand is the fact that, while the seizing of assets in Cyprus arouses angry emotions because it is so blatant and arbitrary, and because 40% seems like such a shockingly-high figure, this same sort of money grab goes on in the vast majority of countries where fiat systems have been imposed.  It has been going on for years, and the "levying" usually amounts to a whole lot more than a simple 40% haircut.  Most governments are just a lot more careful to make it a lot less obvious.

We previously published an article discussing an American Institute for Economic Research (AIER) study entitled "A World of Persistent Inflation," in which we explained that when governments rack up a history of excessive expenditures (usually on wars or welfare or both), they can finance those expenditures by increasing taxation on their people (which is unpopular), or by increasing their borrowing through the issuance of bonds (which generally causes the rate of loans to go up, driving up the rates of borrowing on everything else, and which therefore also becomes unpopular after a while).  To artificially keep interest rates low, governments in charge of their own fiat currencies can mask the cost of their borrowing by printing more money -- inflating the currency.  The AIER study proves with extensive evidence that this last choice has been the overwhelming favorite of governments in charge of fiat currencies for the past seventy-plus years.

In the case of Cyprus, of course, the government could not really issue more bonds (their credit had been reduced to junk status), and the government could not print more money (they use the euro, so that option is closed to them, as it is for Greece, Italy, and the other eurozone countries, unless they decide to try to leave the euro).  Thus, what generally happens in a slow and stealthy way elsewhere just erupted to the surface in Cyprus like a big ugly boil for all the world to see.

But just because it isn't out in the open the way it is in Cyprus does not mean that other participants in fiat systems can breathe a sigh of relief, thankful that they do not have large portions of their wealth sitting in Cypriot banks.  As AIER has shown through their studies over the years, the inflating done by governments takes away the purchasing power of the currency that savers deposit just as surely as if those deposits were levied the way they are in Cyprus.  In fact, although a loss of 40% all at once is a heavy blow, the data AIER has been collecting since 1960 shows that the damage done by the inflation of fiat currencies over time has been far more devastating than any 40% levy (it varies by country and by currency).

This concept is one that all participants in the economy should understand very clearly.  It is one of the reasons why we have always advocated the allocation of some portion of one's wealth to the ownership of  the shares of well-run, innovative businesses, rather than simply "putting it in the bank."

* For a discussion of the morality of taking depositors' money, which the author explains really means "money loaned to highly-levered financial entities," see this article written by Austrian economist and former money manager Detlev Schlichter, published on March 20.