"Suppose the EU were to come through with more funds? All that means is that Cypriots will have to pay more in future debt and interest repayments. In so doing they would saddle future generations with a burden that they had no hand in creating. How is that fair?"

Cyprus Lifts the Curtain

by Peter Schiff

This week financial analysts, economists, politicians, and bank depositors from around the world were outraged that European leaders, more specifically the Germans, currently calling many of the shots in Brussels and Frankfurt, could be so politically reckless, economically ignorant, and emotionally callous as to violate the sanctity of bank deposits in order to fund a bailout of Cyprus. The chorus of condemnation may have been the deciding factor in giving the Cypriot parliament the confidence to unanimously vote down the measures in hopes that Berlin will cave or Russia will swoop in with a bailout.

The decision to inflict pain on both large and small depositors was almost universally described as a historic blunder. But the mistake was to do so in a manner that was not camouflaged by financial smoke and mirrors. In truth, rank and file depositors have been paying, and will continue to pay, for all manner of bailouts and stimulus. (Read about the Stimulus Trap in my just released newsletter). Whether it's through lower interest payments on deposits, inflation, higher taxes, higher borrowing costs, or the accumulation of unsustainable sovereign debt, Cypriots will bear the burden of past profligacy. But the new plan for Cyprus was far too transparent, simple, and direct to survive in a world dependent on deceit and obfuscation. It was dead on arrival.

All over the world, most notably in the United States, Britain and Japan, central bankers are actively pursuing inflation targets of two to three percent. But isn't inflation, which allows governments to pay off debt through the creation of new money that transfers purchasing power from savers to borrowers, just a deposit tax in disguise? (Read more about Japan's plan to do just that). British citizens of all means have been living with such a three percent stealth tax for the past three years, and it is expected to stay that high for at least two more years. Yet a one-time tax of 6.75% in Cyprus is seen as the ultimate act of betrayal?

Many are lamenting that Cyprus' membership in the EU prevents it from devaluing its own currency to get out of the jam. How would such a course be morally superior? Taking actual losses on deposits is no different than taking losses through devaluation and inflation. Both result in the loss of purchasing power. Asking for a depositor haircut at least deals with the problem honestly and immediately. Although it's not quite as honest, devaluation can also be effective.

The same dynamic holds true with bailout funds. Suppose the EU were to come through with more funds? All that means is that Cypriots will have to pay more in future debt and interest repayments. In so doing they would saddle future generations with a burden that they had no hand in creating. How is that fair?

And it's not as if depositors at Cypriot banks, many of whom are reported to be Russian citizens seeking tax havens, were not complicit in the risk taking. Bloomberg reports that over the past five years euro deposits at Cyprus banks returned more than 24 percent cumulatively, almost double the returns on comparable German accounts. The banks were able to offer such returns because they were exposed to riskier assets (i.e. Greek government bonds). What's so wrong with asking those who took greater risks to earn higher returns to give something back when their decisions go bad?

Cypriot citizens, as members of the EU, had the choice to put their deposits in any EU bank. Even after paying the taxes that had been proposed in the bailout, long-term depositors would have made more money by keeping their savings in the high yielding Cypriot banks than low yielding German banks. So what kind of sadistic Rubicon are we crossing?

The predominating fear internationally was not that mom and pop Cypriots would have trouble making ends meet, or that Russian mobsters would have lost any of their questionable fortunes, but that a run on banks in Cyprus would lead to similar panics in Greece, Spain, and then the world at large. As a result, the troubles of an insignificant economy are seen to threaten the entire global financial edifice. This is just the latest sign that our current system rests upon nothing but confidence...which in the end can be ephemeral.

Despite the surmounting mathematical challenges faced by the overly indebted countries, investors have confidence that central banks will be able to engineer a return to sustainable economic growth without creating runaway inflation or triggering a renewed recession through premature tightening. This would be a tall order in even the best of circumstances. But if a small issue like Cyprus can shake that confidence...how strong can it be? Read how this confidence in central bank support has been the driving force in stock market rally.

Interestingly, the troubles in Cyprus have encouraged many to boast about the comparative health of American banking institutions and the superior sanctity of our own depositor protections. Both of these strengths are illusory, and as a result, what happens in Cyprus will not necessarily stay in Cyprus.

This month the Federal Reserve released the results of "stress tests" that it conducted on the major U.S. banks. While the media heralded the overwhelming success, in which 14 of 16 institutions received gold stars, they did not mention how the tests failed to test how the banks would perform if interest rates were to return to their historic norms.

Currently, the ultra-low rates provided by the Federal Reserve, which provide a low cost of capital and sustain profits on highly leveraged bond and mortgage portfolios, are a key element keeping banks in the black. All of that would be threatened in a rising rate environment. And while the tests did assume that rates would rise from the current 1.9% on the 10 year Treasury, there were no considerations for yields surpassing 4%. They assume that interest rates will stay near historic lows, no matter how bad (or good) the economy gets, how high inflation rises, or how much money the government borrows.

The Fed saw yields rising to 4% (by the end of 2015) only under their most optimistic forecast. In the scenarios involving economic deterioration, they predicted yields would come down dramatically from current levels. At no point did researchers ask the most fundamental questions: What if all the money that has been created over the past few years leads to an increase in inflation that forces interest rates past 4% even if the economy remains weak -- do they not remember the stagflation of the 1970s? Or what if the continued fiscal cowardice in Washington leads to a diminishment of bond investors' enthusiasm?

Given our past experience with bursting bubbles, would it not have been wise for the Fed to consider whether banks could withstand the bursting of the Treasury bond bubble, which many suggest is the biggest bubble of them all? But since the Fed did not recognize the smaller bubbles until after they burst, it is not surprising that they are equally blind to this one? The Fed, after all, does not have a history of learning from its mistakes. However, I believe the oversight is no accident. The Fed knows that major banks would fail if the bond market crashed, but it does not want to shake the confidence that is essential to the current economy.

This episode also puts into starker focus the inadequacy of deposit insurance. By offering the illusion of systemic safety in bank deposits, government guarantees encourage recklessness by banks and depositors. They provide the same incentives that federal flood insurance does in convincing homeowners to build on flood zones. Consumer choice and risk aversion are powerful forces that could bring needed discipline to banking. The FDIC in the U.S. is in the same situation as insurance giant AIG before the crash of 2008.

While the FDIC currently has about $25 billion available to bail out failing banks in the event of isolated events (mainly held in U.S. treasuries that would need to be sold), it insures more than $10 trillion in deposits. Clearly it lacks the resources to cover major losses in a systemic failure. A failure of just one of the nation's forty largest banks could swamp the resources of the FDIC. I believe that a significant spike in Treasury yields, to say 6%, would result in the failure of several major banks. Bank of America and Citibank for example each have over $1 trillion in deposits. Where would the FDIC get the money to make the depositors whole in such a situation? The government would be unlikely to pass a major tax increase to fund an FDIC bailout. More likely the Fed would print the money. In that event, depositors may not lose their money, but their money will lose much of its purchasing power. In the end, honest losses could prove to be much smaller.

Link:
http://www.lewrockwell.com/schiff/schiff211.html