Cyprus update

This morning’s agreement outlining a solution to the stalemate that has gripped Cyprus for more than a week was an important development.    The official Eurogroup statement can be found here .

Among the key provisions:

  • Financial assistance up to EUR 10bn for Cyprus
    Reiteration of the deposit guarantee for depositors holding less than EUR 100,000.
  • Laiki bank (the #2 bank in Cyprus) will be split into two – a “good” bank that will be subsumed into the Bank of Cyprus (the #1 bank) and a “bad” bank that will be wound down.
  • Temporary capital controls (e.g., limits on daily withdrawals) to ensure orderly reopening of banks in Cyprus that have been closed since March 16.
  • Uninsured deposits (those over EUR 100,000) remain frozen pending recapitalization of the Bank of Cyprus. The recapitalization will occur “through a deposit/equity conversion of uninsured deposits with full contribution of equity shareholders and bond holders”. The target capital ratio for the recapitalization is 9%.

As noted in my NY Times interview this morning, this is definitely an improvement over the previous proposal and provides some hope that the situation in Cyprus will remain contained.

Some Thoughts on the Cyprus Situation

Watching the Cyprus situation unfold, I have to admit to being amazed / captivated / distraught / panicked (not necessarily in that order). Many times over the past few days I have started to write something only to stop because I didn’t know what to say that hasn’t already been said. But here are a few thoughts about the proposal (vetoed Tuesday in Cyprus’ parliament) that depositors share some of the burden:

(1) It was such a surprise that we’re not even sure what to call it.

This is a bit of an overstatement, I know, because there certainly was a precedent for foreign deposits being at risk of loss after the European Free Trade Association ruling in January regarding Iceland’s limited responsibility to its foreign depositors [1]. But the Cyprus proposal did generate a wide variety of phrases to describe the mandatory participation of depositors, e.g., tax, levy, seizure. The term expropriation also comes to mind – a “deposit grab” for short.

But here’s another way to think about it – an unprecedentedly-negative nominal interest rate. When I first started covering the inflation-linked bond market, I remember highlighting a key distinction between real and nominal yields – the former could be negative whereas the latter could not, in part because no one would tolerate paying a bank to hold their funds when they had a mattress as an alternative. Over time, however, our tolerance for negative nominal yields has increased, albeit mainly under the veil of transactions fees. And while the discussion over quantitative easing often centers on what happens when a central bank reaches the zero lower-bound, in practice there have been some brief examples where the bound has been breached [2]. Perhaps the deposit-grab has taken quantitative easing to a whole new level.

(2) Banks more generally face a deposit catch-22

What this situation in Cyprus has highlighted is just how important deposits are to the health of the financial system. At some level, this was already known – on one hand, deposits are a source of liquidity for a bank. It’s one of the reasons why when a bank fails, its deposits are usually quickly taken over by another institution (related to the reputation point above, this also means that deposit guarantees are rarely required to pay out). But just as quickly as they appear, deposits can also evaporate. More deposits means more liabilities, requiring a bank to hold more capital to protect itself from a potential erosion. As a result, deposits are linked to capital ratios.

One way to reduce the liability side of a bank’s balance sheet and hence improve its capital position is by shrinking its deposits. The direct threat the proposal posed to deposits, even though rejected, suggests that the objective may be fast achieved. Hence the proposal that depositors share some of the burden may have been a misguided attempt to provide much-needed liquidity while at the same time improving the capital position of the banking sector.

(3) Reputation has taken a huge hit

Whenever I talk about the recent financial crisis, one of the things I highlight is the importance of reputation when confronted with challenges. Like regulatory capital, reputation serves as a buffer providing a firm, or a sovereign, with the ability to overcome difficulties. Without it, things can quickly spiral out of control.

The proposal that emerged over the weekend on Cyprus has irreparably damaged reputation at a time when it is most needed. Gone is the credibility of political leaders – just one week before the proposal was announced, Cyprus’ president said losses on depositors were “out of the question”. This is reminiscent of assurances various banking chief executives made in the early stages of the financial crisis – our confidence has been thoroughly undermined. Gone also is the credibility of the European deposit guarantee. Now that a deposit-grab has been put on the table, it is hard to envision a clear path to reopening the banks in Cyprus while avoiding a massive deposit outflow (as I write this, the “bank holiday” has been extended through the weekend).

[1] Duxbury, Charles, and Charles Forelle, “Iceland Wins Case on Deposit Guarantees,” Wall Street Journal, January 28, 2013, available at

[2] Keister, “Why Is There a “Zero Lower Bound” on Interest Rates?” Liberty Street Economics blog, Federal Reserve Bank of New York, November 16, 2011, available at

Fed Policy Drives Equities: Just Released Money Supply Data

Today, CFS monetary and financial data should help the Federal Reserve and market participants refine relative costs and benefits from the present monetary policy mix.

Our study shows how the policy of purchasing Treasury and mortgage securities by the Federal Reserve or quantitative easing (QE) accentuates swings in equity markets.

Yet, recent gains in CFS Divisia M4 are consistent with improved economic growth of 2.5% to 3%.

For Monetary Notes and Views:

For Monetary and Financial Data Release:

Campaign to Fix the Debt Letter

The Campaign to Fix the Debt has worked with former presidential
advisors and more than 150 economists and thought leaders to pen a bipartisan letter urging that Congress and the President enact a plan now that strengthens our economy, phases in gradual but necessary reforms, and puts our national debt on a downward path relative to the size of our economy.

As friends of the CFS know, we have enthusiastically promoted the idea of debt and deficit reform in the United States.

The Campaign’s letter can be viewed here.

For CFS work on specifics:
The Financial State of the Union, September 20, 2012
Demand for U.S. Debt Is Not Limitless, WSJ, March 28, 2012
Budget Solutions: Then and Now, July 19, 2011
Treasury Maturities: The Other Fiscal Problem, March 10, 2011
Hidden Risks from Expanding Governments, May 11, 2010

New Bowles-Simpson Proposal

On Tuesday the dynamic bipartisan duo Erskine Bowles and Alan Simpson was at it again –releasing a new/updated set of recommendations for dealing with our debt situation. Although the exact details differ, seven of the 11 principles outlined in the summary closely resemble those given in the original 2010 Fiscal Commission Report (available here). Of interest, therefore, are the looming risks to economic stability highlighted in the four new principles. They are (the exact wording from their proposal is highlighted below in bold):

(1) the threat of sequestration (Replace Dumb Cuts with Smart Reforms),
(2) the increasing debt burden (Protect the Full Faith and Credit of the U.S. Government),
(3) the changing demographic landscape (Get Serious About Population Aging), and
(4) the rising cost of health care (Bend the Health Care Cost Curve).

There is already plenty of discussion out there regarding sequestration since its deadline looms. Here is why I think the other three are so vital for the financial future of the US.

Protect the Full Faith and Credit of the U.S. Government:  In addition to the magnitude of the debt burden, the front-loaded US Treasury maturity structure is worrying (see “Treasury Maturities: The Other Fiscal Problem” by CFS President Lawrence Goodman). With a large proportion of debt maturing in the near-term, coincident timing of a Treasury rollover of that debt and a Fed exit from quantitative easing could result in the perfect storm, raising borrowing costs substantially. Put another way, one wonders whether the threat of substantially ballooning borrowing costs may limit the speed at which the Fed can raise interest rates.

Get Serious About Population Aging / Bend the Health Care Cost Curve:  I’ve been quite vocal with my view that the changing demographic landscape is one of the biggest risks to global financial stability (see “The Market for Long-Term Care Insurance and Systemic Risk“). Anecdotally just consider the number of countries and corporations that have highlighted the necessity of pension and healthcare reforms – and the hostility from current and future beneficiaries that any proposed modifications generated. I’m glad to see this topic garnering greater attention – policies that address financial stability and systemic risk have implications for healthcare and vice versa. Unintended consequences can result when policy debate about one occurs without consideration of the other.

The new Bowles-Simpson proposal also contained an outline of “Four Steps to Deficit Reduction (2014-2023)”. In Step 3 they reiterate their call for adopting a chained CPI for indexing (i.e., of entitlements like social security). I continue to be concerned about how this proposal might be implemented, specifically with respect to its redistributive implications (see “Changing Inflation Won’t Solve Budget Woes“). We must be careful that such a change will still “Protect the Disadvantaged” (one of Bowles-Simpson’s earlier recommendations that was reiterated in their new proposal).

See also:Budget Solutions: Then and Now“, by Susan Hering and Lawrence Goodman.

Overstated Hit to Retail Spending

The WSJ this morning published a terrific piece on the hit to retail spending due to the 2% hike in payroll taxes (see Payroll Tax Whacks Spending).

To be sure, higher taxes are problematic.  However, the piece overstates the damage from this one measure to the overall economy.

Prior to posting the CFS monetary aggregates and components earlier this week, we combed the data for key themes such as the impact of the payroll tax hike on the economy.  It is clear that the 2% boost in payroll taxes marginally reduced liquidity in the banking system.  However, the small decline in bank deposits could also reflect the drawing down of funds to invest in strengthening stock markets.

So on balance, the payroll tax hike is an unfortunate drag on growth.  However, the financial system is heeling.  Banks and corporations are flush with liquidity.  So even if retail spending is reduced on the margin (the WSJ notes that a family with an annual income of $65,000 will lose just over $100 per month in spending power), corporations are and will continue to invest.  This too is clear from the CFS monetary and financial data.

Better Growth Ahead: Money, Markets and the Fed

Today’s Forbes column by Lawrence Goodman notes that:

The economy seems to be coming back and is stronger than indicated by the GDP statistics released this morning. The Fed may reach its 6.5% unemployment target sooner than many expect.

The financial sector appears to be on the mend – based on CFS money and banking data.

Corporate cash balances are beginning to migrate into the economy.

Financial market distortions – as evidenced by the value of bonds and stocks – are at extremes not witnessed in over 90 years.

To view the column:

View on WSJ “QE’s Impact Defying Logic”

The Wall Street Journal’s Tom Lauricella wrote a thoughtful piece this morning called QE’s Impact Defying Logic.  The story focused on FX markets.

I enjoyed the perspective.  However, two counter examples resonate:

1) The comparison is largely against the majors.  Countries from Korea to Costa Rica to Brazil are screaming about outsized currency moves and pressure.  This is due to QE by the major central banks.  So, QE is impacting currency markets.

2) QE is also having a dramatic influence on asset prices – see

The article raised the point that if inflation ultimately pushes higher in the US, major currencies will suffer.  The question remains.  Which one will fall furthest?

We believe that the CFS monetary and financial data will help provide an early warning signal.

View on “Chinese Currency Manipulation Is Not the Problem”

In a recent WSJ op-ed Chinese ‘Currency Manipulation’ Is Not the Problem (Jan. 8), Edward Lazear concluded that the valuation of the Chinese yuan (CNY) is irrelevant for trade.  This is highly mistaken.

Lazear correctly noted that the Chinese trade surplus mushroomed during the period 1995 to 2005, when the CNY was pegged.

However, the analysis misses the fact that the CNY was actually undervalued at the start of the period referenced.  A whopping 60 cents was needed to purchase one yuan in 1980.  By 1995, the currency had fallen to a scant 12 cents.  Based on our calculations of currency valuations across a universe of 49 exchange rates, no currency was as undervalued as the yuan in 1995.  So, even if the price of a product or currency increases over time, smart consumers will still buy if the product is still cheap.

In recent years, the People’s Bank of China (PBOC) and National Development and Reform Commission (NDRC) have introduced greater flexibility into CNY trading.  This has helped reduce the trade surplus from a peak of $300 billion in 2008 as well as promote a shift from exports to domestic consumption as drivers of demand.