How many of us had thought about Cyprus until this week? How many of us were aware that Cyprus had become a global tax haven with a obese banking sector about 8 times the size of its tiny GDP? (Banking sector in Europe is 3 times Europe’s GDP & US banking sector is 1 times US GDP). How many of us knew that Cyprus was now a haven for Russia’s wealthy, especially Russian billionaires? Russians are the largest depositors in Cypriot banks, reportedly to the tune of 30 billion euros or more.
In contrast, every one knows that China is the largest investor in U.S. Government Bonds. It is common to hear China described as America’s Banker. In the last decade, China preferred to buy higher yielding Agency securities, bonds issued by Fannie Mae, Freddie Mac that were assumed to be implicitly backed by the U.S. Government. By 2007, China owned several hundred billion dollars of Fannie Mae, Freddie Mac bonds.
But what does that have to do with what’s going on in Cyprus? That’s the story of this article, the story of a huge cultural & intellectual difference between America and Germany, the difference that might have a big impact on the American & Global economy.
The European Monetary Union is dominated by Germany, the industrial & financial powerhouse of Europe. The problem in Cyprus is tiny compared Europe’s GDP. Cyprus merely needs $15 billion to make today’s problem go away. Bailing out the Cypriot banks with $15 billion and then restructuring them quietly would be a sensible solution. And Cyprus banks are in trouble because they bought Greek Government Bonds during the recent bailout of Greece. Every EU banking sector was mandated to buy Greek bonds as a gesture of European solidarity.
But none of this matters to Germany and its dominating leader Angela Merkel. She has taken a firm stand that German tax payer money cannot be used to bail out wealthy Russian depositors in Cyprus. As Christopher Mahoney, former vice chairman of Moody’s writes in Project Syndicate:
- “Germany is happy about the Cyrpus banking crisis because it will punish Cypriot sinfulness. I guess the sin is that the eurozone is no place for an offshore banking center/tax haven, which is debatable… Now its banks have EUR 50 or 60 billion in euro-denominated deposits which Germany wants it to default on. The Journal says that “one reason that Berlin is taking such a hard line on Cyprus now is that it sees the country’s crisis as a unique opportunity to end its reliance on tax refugees”. This is punishing shoplifting with the death penalty.”
This German stance is diametrically opposite to that taken by Secretary Henry Paulson in 2007 when he put Fannie Mae & Freddie Mac in conservatorship. That action wiped out preferred securities of Fannie Mae & Freddie Mac that were owned by virtually every bank in America and millions of American individual investors. That action would have and should have made Fannie Mae & Freddie Mac bonds worthless too. If millions of American investors & American banks lost their investments, then Chinese government investors should have also lost their investments in Fannie Mae & Freddie Mac, right?
Instead, Secretary Paulson & President Bush decided to protect Fannie Mae & Freddie Mac bonds from the conservatorship action. They protected Chinese institutions from a wipeout while they let American banks & American investors lose a tremendous amount of money. They understood that wiping out foreign institutional investments in US government sponsored agencies would irrevocably damage America’s financial markets.
The world understands that America’s greatest advantage is its financial system, the system that has built the largest, most liquid and most free financial market in history. The European monetary union was an attempt to build a counterpart in Europe. As Christopher Mahoney writes:
- “The West has spent the last sixty years building an institutional framework to allow global trade and capital flows. This has meant the dismantling of currency controls, capital controls, trade barriers and barriers to foreign investment….The eurozone was supposed to be an enhancement to the globalization of finance. It was supposed to do for the eurozone what the dollar zone has done for the Americans…..If eurozone bank deposits now become subject to sovereign risk, that will reverse the whole process.”
So why is Germany risking so much for so little? Christopher Mahoney opines:
- “Germans are very skilled at making things and being thrifty. They are economically admirable in every way except one: they have never accepted modern capital markets. They have resisted anglosaxon capitalism for forty years, and they still don’t accept it. Germany (like France) believes in intermediated financial markets which can be controlled by the authorities in order to ensure financial stability. They don’t trust independent market actors like hedge funds, US investment banks or rating agencies.”
We think Mr. Mahoney is absolutely correct in his analysis of the German mind. Germany despises the American-led financial technology model. This is why the EU, under German orders, is imposing stupid restrictions on banker bonuses and creating a banking order that will damage global growth. It is an attempt to replace the financial infrastructure model with an industrial economy model.
Germany believes in its model of becoming a great industrial power, creating jobs at home and exporting its superb machinery to other countries. Angela Merkel, a Physics Ph.D., despises an economic structure based on finance. This moral puritanical attitude and her “outspoken distaste for Russian kleptocracy” “is behind Germany’s fervent desire to use Cyprus as an example of what happens to “sinful” countries. But Frau Merkel ignores the grim reality of Europe.
The reason Germany is strong today, the reason their export-driven model works is because the rest of Western Europe has become Germany’s captive market thanks to the European monetary union. Over 50% of German exports go to countries in the European union. This system has made Germany a rich trade-surplus nation while the rest of Europe has become poorer with large trade deficits. Now Germany proclaims that the problems of Greece, Italy and Spain are due to the faults, the culture & work ethics of these non-German countries. In Cyprus, Germany has gone from being merely outspoken to imposing draconian punishment.
Once again, Germany is imposing its will & subordinating the rest of Europe, attacking Russian interests and breaking away from the global Anglo-American system. No wonder, Mort Zuckerma
n, a sane, rational, and knowledgeable American voice, is extremely worried about Cyprus:
- you are looking at an absolute accident that is about to become a tragedy… I don’t see how they stop it, no body is going to be able to bail them out…so many other countries in Europe that are going to have to be bailed out… where is the money going to come from? what is it gonna do to the Euro? what is it gonna do to the European Union? …. there is going to be an event that is going to happen and that is going to destroy the whole fabric, the sheer fabric of confidence in the financial system in Europe…. and who knows where that goes? we have not ever seen anything like that? It will have huge impact on the United States as well..
The reason America works is the wisdom of its leadership, the deep understanding of Robert Rubin & Henry Paulson that the sanctity of the financial system is paramount. This is why Secretary Rubin bailed out Mexico in 1994 and why Secretary Paulson protected Chinese investments in Fannie Mae, Freddie Mac in 2007.
That was never the German way and it is still not the German way as they demonstrated this
week. Their approach could turn Europe into Latin America as Christopher Mahoney argued this week:
- “Southern Europe is at risk of going back to a Latin American-style financial system. Latin American depositors instinctively understand that you must keep your company’s money and your family’s wealth in a hard-currency deposit in a big bank in a strong country. Southern Europeans used to know this: it was called a numbered Swiss bank account. They are relearning this lesson. “
Let us hope Germany comes to its senses or the rest of Europe unites to force a change. But that might have to wait until after German elections scheduled for September 2013.
In the meantime, let us all pray for a financially quiet summer.
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