Macroeconomic lessons in fast forward mode
On the ides of March 2013, Cyprus captured the world’s attention and imagination. Despite the protestations on all sides that Cyprus is a “special case”, the reason it received such prominence was precisely because in Cyprus some of the major unresolved issues about the world economy could be seen in their starkest form. Many issues that had been in the background of world developments since 2007 and from which many had tried to avert their gaze, could not be so ignored in the case of Cyprus.
The speed of developments and the way things unfolded in most cases stole the limelight and forced evaluations and prejudged stances towards the problem. It is easiest to see what the Cyprus problem is not: it is not a North-South issue, as presented by the majority of commentators in Greece and in Cyprus. It was not primarily an issue of punishing a “money-laundering centre”. It was not due to the Greek PSI (haircut of government bonds), or other impacts of the Greek crisis.
What was the underlying theme that caught the world’s attention? We would submit that in Cyprus the same issue resurfaced that had been met in the case of the financial crunch of 2007 in the US, the collapse of Iceland, and the rescue of Irish Banks. In other words, the relationships between the real economy and the public finances on the one hand, and the financial sector and banks on the other. Since 2007 it has repeatedly made obvious that the size of the financial sector had grown far beyond the capacity of the real economy to underwrite. This is not a new issue. James Tobin, already in 1984, doubted the wisdom of the runaway growth of the financial services sector.
Cyprus showed the issue in stark form, because for the last 20 years it had based its very rapid growth on becoming an off-shore financial centre. As a result, when its banks failed, the real economy was self-evidently too small to support them. In Ireland, the same issue led to the imposition of austerity for three years and bailing out of the rich by the poor. After much heart-searching, the same issue was resolved in Cyprus by treating large bank depositors as if they were investors (and forcing losses on them, applying the principle of caveat emptor). Hence, for the first time in the EU, large deposits were treated as risky investments. This raised howls of dismay. The apocalyptic predictions failed to materialise in the rest of the Eurozone, even in the South. This underlines the exaggeration in identifying the fate of the economy with the narrow interests of the financial lobby.
Taking a broader view, in the last decade whereas forms of wealth connected with the real economy (shares, business profits, real estate) had taken a battering, bank deposits were deemed sacrosanct, even though the real return in the Eurozone was boosted by near zero inflation and the ease of tax avoidance for the large investors.
Risky banks had to offer high risk premia to attract deposits; yet, when the risk that was thus compensated materialised, compensation was invariably given by tax-payers.
The Cyprus rescue reminded investors that dealing with the debt overhang can be attained not only via the real economy, but also through the finance sector. The writing on the wall for this has been around for a long time. The lesson was taught in Cyprus in the space of two weeks. This abruptness will doubtless bring a deep recession for this years and the next. However, the realisation that the business model that had been so successful for two decades was no longer feasible, is no doubt a valuable lesson.
Cyprus will have to reinvent its role after this painful change. Finland in 1992 successfully managed such a reinvention, after the collapse of the USSR. Cyprus itself managed it after loosing 30% of its territory to the Turkish invaders in 1974.
If one can look through the short-term gloom, it is not unreasonable to hope that the search for a new economic model will bear fruits. After all, the reason the money came to Cyprus was because of its people and their creativity. Some of the capital might leave, but people will be there. Christopher Pissarides, the Nobel laureate labour economist, recently stated that financial services sector is fully possible even in the absence of big banks.
However it may be, it has been proven beyond doubt in the space of two weeks that the economic model followed in Cyprus over the past decade was unsustainable. This certainty, in a way, gives a kind of luxury compared to a more gradual awakening. This may be seen as an opportunity to be grasped in order to allow the search to be more broadly based.
What would this new model contain? It will be made apparent only gradually. However, there is one aspect of banking-centred growth model with which at least one half of the population in Cyprus will be glad to part with. One of the least commented aspects of the Cyprus model was that it was characterised by the largest gender wage gap in the EU for women over 45 years, but also one of he largest gender pay gaps in the private sector (by a factor of 25 percentage points). The chance to start afresh should at the very least provide an answer to this glaring inequality. If the new economic model is more broadly based, it will be able to draw upon the contribution of that part of the population, which Casino Capitalism has left behind.
