The X-Factor for Market Fallout: Erosion of Confidence in the Financial System

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Since 2009 we've watched analysts and commentators seize on crisis talking points. Often times, we were right there ringing the alarm bells.

Trying to predict the next black swan -- an impossible feat -- became the tactic du jour.

Despite some significant pullbacks each of the last three years, the general direction for global markets has been UP.

Yet in that same period of time financial markets faced no shortage of risks.

So if central banks and policy makers can claim any success since crisis hit markets in 2008, it's that they've been able to shore up social mood so that markets could recover and drag sentiment higher alongside.

Enter (and perhaps exit?) Cyprus ..

We received an email, after some of our initial comments on the Cyprus fiasco, asking this question that's been circling the financial blogosphere in one form or another:

What is so different in Cyprus from what we have here with zero interest rates which are a long term consistent confiscation of savers money? Five years of this makes 40% confiscation by Madam Lagarde look cheap.

My answer: 

The difference: it's more abrupt; and it's a lot more tangible (for people who can't understand or don't care to understand the implications of artificially low interest rates) because this simply shifts resources from the household sector to the financial sector.

I also provided this quote from Henry Ford: 

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

The planned confiscation of uninsured deposits in Cypriot banks is setting a precedent. Capital controls, it would seem, will only intensify the concerns that other problem countries in the eurozone may make a beeline for bank deposits to stave off recession and/or meet bailout conditions resulting in depositors pulling out their cash at the first sign of new financial pressures.

Already Spain is trudging an eerily similar path, as noted in a WSJ story included in a Good Reads post last week. 

To be sure: the market has become accustomed to "solutions" from Eurozone officials. And the market seems to recover more and more easily each time around. Additionally, a collapse in Cyprus' relatively tiny economy cannot by itself bring down the Eurozone economy.

But the nature of the solution and earlier proposals has amounted to a blatant encroachment on personal property (as opposed to the more inconspicuous encroachment of quantitative easing and low interest rates.) 

Consider this from Wolfgang Munchau writing in the Financial Times:


Cyprus is more likely to return to debt sustainability outside the eurozone, because a lower exchange rate would reduce net debt, and because of a faster resumption of economic growth.
The same is ultimately true of Spain as well. Jeroen Dijsselbloem, Dutch finance minister and president of the eurogroup of eurozone finance ministers, unwittingly answered that question when – in an interview with the Financial Times – he shocked the world by telling the truth. It is now the stated policy of the creditor countries to solve the problem of a debt overhang in the banking sector in the peripheral countries through the bail-in of bondholders and depositors.
…The logical consequence of Mr Dijsselbloem’s dictum and the reality of austerity and a deficient banking union is a future bail-in of Spanish bank bondholders and depositors.
The problem is that even insured deposits will then not be protected. Look at what happens in Cyprus, where capital controls affect small and large deposits alike. I would expect that to happen in Spain as well. Given the stated policy, it is logically irrational for any Spanish saver to keep even small amounts of savings in the Spanish banking system. There is no way that the Spanish state can guarantee the system without defaulting itself.
While the markets have been able to shrug off economic risks thanks to policymaking, many individuals have not been so fortunate. Global housing markets and unemployment come to mind.
And though analysts are becoming more optimistic for the US economy, their projections may be based on the US's position relative to major counterparts. The eurozone is in bad shape. The UK economy is at risk of a technical triple-dip recession. China seems to have stabilized but the risks of closely managing the economy remain.
And even though I agree the US is being looked at as a least-bad option -- the US markets representing a sort of default safe-haven -- it's hard to argue the economy is actually healthy. Consider this excerpt from a New York Times article (my emphasis):

Since the S.&P. 500 first reached its current level, in March 2000, the mad money printers at the Federal Reserve have expanded their balance sheet sixfold (to $3.2 trillion from $500 billion). Yet during that stretch, economic output has grown by an average of 1.7 percent a year (the slowest since the Civil War); real business investment has crawled forward at only 0.8 percent per year; and the payroll job count has crept up at a negligible 0.1 percent annually. Real median family income growth has dropped 8 percent, and the number of full-time middle class jobs, 6 percent. The real net worth of the "bottom" 90 percent has dropped by one-fourth. The number of food stamp and disability aid recipients has more than doubled, to 59 million, about one in five Americans.

So the Main Street economy is failing while Washington is piling a soaring debt burden on our descendants, unable to rein in either the warfare state or the welfare state or raise the taxes needed to pay the nation's bills. By default, the Fed has resorted to a radical, uncharted spree of money printing. But the flood of liquidity, instead of spurring banks to lend and corporations to spend, has stayed trapped in the canyons of Wall Street, where it is inflating yet another unsustainable bubble.

When it bursts, there will be no new round of bailouts like the ones the banks got in 2008. Instead, America will descend into an era of zero-sum austerity and virulent political conflict, extinguishing even today's feeble remnants of economic growth.

Seriously -- "no new round of bailouts ..."? Why not?

I wonder if the way officials dealt with the Cyprus bailout was merely an experiment. Forcing the burden on depositors and creditors, as they're doing with Cyprus, changes the dynamic to which markets have become accustomed, i.e. endless monetary stimulus and fiscal massaging.

To be sure, depositors, creditors and investors should be exposed to losses just as they are exposed to gains. But their funds should not be effectively confiscated so that government can restructure banks and arrange bailouts.

Consider the model that's developed from federally insured banking -- nobody does their due diligence in finding a healthy bank because their deposits are guaranteed by the government. This allows bad banks to be coddled and actually grow to the point where they become systemically important even if their practices don't merit such.

What Cyprus's experience has served to do is bring the fractional-reserve, federally-guaranteed financial system under increased public scrutiny. So not only do the taxpayers see danger in potential bank failures, but depositors, investors and creditors now also see risk in policies that perpetuate an irresponsible banking system.

Bailouts and stimulus have become politically unpopular in the US. And government will have a rough go with any rescue packages they might have to propose. The private sector may force the system to take its medicine, and, if so, it's a good bet the markets won't like the taste one bit.