Cyprus – Cinderella and the Ugly Sisters

The oldest known version of the Cinderella story dates back to ancient Greece – how ironic.

Cyprus was, for many years, an idyllic island – originally settled by Mycenaean Greeks around 4,000 years ago. Known for its beauty and its beaches, it became a tax haven before 2004 when it joined the European Union. Its economy benefitted enormously – Cyprus did, indeed, go to the Ball.

The Sisters turn Ugly

Yet Cyprus is now being rejected by its two ugly sisters – the EU and Russia, who have conspired with Cyprus throughout the last ten or so years by enabling illicit money to flow into the country. Cyprus has benefitted from its relationships with the EU and Russia but those sisters are now turning ugly.

Isaac Newton was an alchemist but even he could not transmogrify base elements into gold. Modern counterparts are far more able to magically transform base elements into gold on a massive scale that would amaze even the alchemists of the seventeenth and eighteenth centuries. Now that money is digitized, base elements (the profits made from illicit activities) can be changed in seconds within banks situated in secret jurisdictions.

The essence of the problems in Cyprus is that a vacation destination, home to many hard-working and energetic people, has been itself transmogrified into an offshore banking centre that is many times the size of the rest of the economy. That the part of Cyprus within the European Union is close to bankruptcy is astonishing enough to many.  Even more astonishing is the evidence that is mounting about a small country enriched in the short-term by a Faustian sale of its soul to Russian criminals.

Cyprus is an island with around 1 million people and a GDP of around $24 billion. Some years ago, the government of Cyprus decided (or was persuaded) that attracting huge sums of digitized money from wherever it could get it would increase their income. So, through increased secrecy laws, a multitude of double-taxation agreements with other countries and low tax rates in Cyprus, it created itself as a tax haven. Russians, for many years with interests in the country, flocked to Cyprus – preceded by their money. Cyprus became a home of money laundering as well as a tourist destination. The combination has been very powerful.

The banking crisis

When the sub-prime crisis hit in 2007/8, Cyprus was enjoying substantial growth. However, it had followed the high interest rates in Greece and invested in Greek banks. When they failed so famously (requiring massive “haircuts” from those investing in them), Cyprus – massively over-extended in them – suffered badly.

While its two ugly sisters worked out a way to enable Cyprus to be the beneficiary of illicit hot money for many years, one ugly sister (the EU) rebels at the thought of such mismanagement leading to a call on it to prop it up. While the EU is full of tax havens – from the City of London to Luxembourg to Austria – the political will of members of the EU such as Germany to continue to prop up Cyprus is vanishing fast. Hard-working German taxpayers, already riled by the needs of Greece, the political anarchy in Italy and the mass youth unemployment in Spain, have been further spooked by the machinations of discredited politicians in Cyprus – already in hock to the Russian mafia on a grand scale. This is why they demanded a contribution from Cypriots that resulted in the mass demonstrations in Nicosia and elsewhere as the middle classes were confronted by the fact that their insured deposits in Cypriot banks were not, after all, insured against the EU.

Where’s the Fairy Godmother?

Cyprus now realizes that its pact with the devil (Russian mafia) and its focus on becoming a secretive, tax haven has turned sour. To remain in the EU, it needs to save its banks. To save its banks, it needs to raise significant sums from its people (in terms of further tax revenue or long-term bond issues) and also from other, overseas, depositors. The latter are mainly Russians – and much of that money is illicit. The mere thought of taxing the Russian mafia is enough to make the story of Cinderella into a horror film – that might make the new wave of horror films based on fairy tales (such as Hansel and Gretel – Witch Hunters) look insipid by comparison.

There appears to be no Fairy Godmother who will let Cinders go to the Ball. It seems to be the case that Cyprus is between the rock and the hard place – between two ugly sisters: one that has plied it with funny money for years, the other that has conspired with it to do so and stayed quiet until now.

Greece has suffered five years of depression. The problems for Cyprus are only just beginning but whereas Greece’s problems remain its own, Cyprus is in much more danger – it is in hock to a mafia-ridden nation and appears to have few friends within the EU who are willing to turn it around. For its people, this could be a disaster – economically and also in terms of the way of life for its citizens. The EU allowed this situation to develop – it should not be blind to the plight of its smallest member. It is enough that fear has been struck into the citizens of Cyprus and to those in Italy, Greece, Spain and maybe France, who now know that bank deposits are not theirs any longer. Bank runs come from times like this.

Allowing Cyprus to be so wayward for so long is bad enough – to allow it to go completely off the rails and into the clutches of a mafia state would be too far.  Cyprus needs a short-term remedy and a long-term plan to get it away from the drug of tax havens. The EU has to turn from Ugly Sister into the Fairy Godmother (and stay the course) or this may well be a Lehman moment that will not easily be forgotten.

Good Global Citizenship and Tax Havens

Barclays was cornered this week in the UK by Her Majesty’s Revenue and Customs into paying back around £500 million for entering into a tax avoidance scheme – despite signing up to a Government scheme not to do such things. Bob Diamond now looks foolish after his vow to make Barclays a good citizen.

For many years, it has been “OK” for companies and high income earners to shield their earnings behind tax avoidance schemes. Since the introduction of welfare states across the world, companies and individuals have sought to minimize the tax that society needs to work through the system. They have systematically sought to challenge the efforts of democracies to manage the tax base. In some countries like Greece, there has been a tacit buy-in by Governments (and those in Government with their fingers in the till) to allow tax to go unpaid. This leads inexorably to financial chaos and, as we now see in Greece, to progressive civil strife and poverty. This is what has happened in Africa for so long – the wealthy shield their income from the State (who are paid off to look away).

In those countries which do make a real effort to collect taxes, the best tax avoidance comes through the use of tax havens and the real killer for economic equity is the way the world accepts tax havens as a reasonable and acceptable part of our global economy.

David Cameron and many others talk a lot about fairness: the fairness that makes bankers bonuses almost a criminal offence. But, this is two-faced. While George Osborne says that the HMRC will work towards killing off general tax avoidance schemes, we have in our midst a main centre of tax avoidance – the City of London.

Nicholas Shaxson wrote brilliantly in his book “Treasure Islands” about the tax havens that bedevil the world of finance and economics. Tax havens distort, they do not equalize.  Tax havens provide the wealthy (individuals and corporates) alongside the wealthy criminals and wealthy terrorists with the ability to shield themselves from legitimate taxation. Providing a legitimacy to tax havens (and allowing them to proliferate worldwide – even shielding them as the UK does the Cayman Islands and elsewhere) creates massive market distortions and inequalities. Legitimate and democratic tax collection is continuously stymied by the tax havens – just a step from the wealth-grabbing in Angola or the tax avoidance mentality that is Greece.

Taxation is a central plank of democratic society.  While the Tea Party and similar libertarians might rage against central government tax and tax collections as a scourge of society, we know that society is centred on a democratic ideal of the wealthy properly financing the society on which it depends to provide a basic source of welfare to the poor and sick, for defence, for infrastructure. Society is more than just the wealthy and privileged creating an elite life. Angola is a good example of how fortunate elites manipulate the wealth of a nation to appropriate its total wealth and Sonangol (its so-called publicly owned oil company – really commanded by its country’s leadership who reap its financial benefits) has been built to achieve the grabbing of oil and energy wealth from the citizens.

The nations that democratically elect their leaders (and, it is to be hoped the new rich of China and Brazil and others) should take heed to the dangers posed by the examples of the wealth grabbers in the energy-rich nations. It is here, in the UK (City of London, Jersey), the USA (such as the state of Delaware) as well as the better known haunts of the Dutch Antilles or the Cayman Islands, where huge financial flows (from the legitimate wealthy alongside the illegitimate) travel in order to reduce the legitimate tax take of the countries in which the wealth is created. Tax havens are wealth destroyers.

Wealth is destroyed by tax havens because they eat away at the main body of a nation – its mass of people, its true wealth creators. Education and education systems suffer dramatically because taxation is unavailable to finance schools. Health systems suffer for the same reasons – in the UK, where we have moved vast sums to the NHS in the last Government, cut-backs are now biting as the tax take is diminished along with economic growth. In poorer countries, the wealth shift is much more dramatic.

Ambassador Nancy Soderberg (appointed by President Obama earlier this year) was in London this week to campaign for Argentina to live up to its duties in economic areas. She mentioned its lack of adherence to the Financial Action Task Force  (FATF) requirements for responsible national supervision of illegal financing – Argentina was placed on FATF’s grey list over corruption issues. But, FATF and other international bodies have failed to oversee a sustained reduction in how financial flows travel the world and to institute a level of good citizenship on a worldwide scale amongst our companies and wealthy individuals.

While steps have been taken to reduce terrorist financing and, to a much smaller extent, the benefits of illegal drug trafficking and gambling and prostitution, very minor shifts have been made in (a) defining what global good citizenship means (b) reducing tax havens and the financial flows through them.

The G20 states from time to time that tax havens are to be reduced in scope but the battle against them has hardly started. Tax avoidance on a grand scale is as bad as grand corruption (maybe bigger in scale): two sides of the same coin. Good global citizenship requires a new definition to be made – where a global consensus is sought to reduce hugely the ability of companies and individuals to create their wealth in one place and move it offshore to save tax. This simple example of good global citizenship is a cornerstone to increasing wealth creation on a wider scale. It is not socialism but realism and pragmatism. It is good citizenship.

Banks and Time Travel

So, Mr Stephen Hestor of Royal Bank of Scotland was pressured into giving up his bonus by a Parliament that threatened to vote against it.

So, Mr Fred Goodwin gets be-knighted by a committee advising the Queen.

Ancient institutions – the royal family and the House of Commons – are playing that old game (which the politicians invariably lose) about who is in charge – government (be they democratically elected or through birth) or the banks? Governments (at least the democratically elected bits) change with the whims of the electorate – banks and banking survive because money is the root of all our economic prosperity – banking is the provider of dreams.

It is a very old game. Since well before Nathan Rothschild strode above the travails of mid-19th Century politicians who were desperate for his bank’s money to fund their economies and wars, banks and bankers have formed their own super-economy – one that economists and politicians have progressively failed to explain or manage.

While the Royal Bank of Scotland saga focuses on bankers’ pay and the balance of reward between employees and shareholders (i.e. who should gain most from banks’ profitability), this misses the crucial issue completely.

What is it that makes banks and banking so critical to world economies in a way that no other industry is so that we are willing to allow them monopolistic rewards – the rewards akin to a totalitarian regime? More than this, how is the overall financial services industry – of which banks are just part – changing and how does it need to change to best serve people and real wealth producing companies, people and our governments in the 21st Century?

What are banks for?

At a simple level, banks are there to provide the alchemy to the economic system – they are asset transformers (David Llewellyn – the New Economics of Banking – 1999). Banks and financial institutions transform money received into money loaned. They transform short-term into long-term. They make tomorrow’s needs available today by making money work hard.

This transformation process (the essence of monetisation ever since the ending of barter economies) has been a crucial bedrock on which economic growth is based. The wealth effect of the asset transformers has been to bring forward tomorrow’s growth into today or next year’s into this or the next generations into this one. This time travel – the bringing forward of the future – is seen whether it is Governments spending trillions today to pay back in future generations, companies bringing forward projects on the basis of payback in three to five years all the way to purchases made on credit cards to pay back (or not) in a month or six. Banks and financial institutions have developed ever-more sophisticated ways to drive the transformation.

Sub-prime problems in 2008 showed, like most banking crises, the fault line in the world’s financial system – the cracks that often appear in that bedrock.

Pressure builds up just like the earth’s crust before an earthquake as financial institutions offer more and more high risk promises to transform the future to the present. In this case, promises to those who could never repay to buy properties they could never afford. It could have been corporate over-stretching. It could have been government over-spending – as it has now become: a massive sovereign debt crisis in the western economies.

The short-term bonus culture of the banks was and remains a symptom not the problem. The battle between senior bank employees and their shareholders is not the problem. The essential risk nature of banking (and there never has been a safe period when bankers were just bank managers who would not give loans – this is a myth circulated while banks were providing high risk loans throughout the corporate and national world) is that the asset transformation process (this time travelling capacity to bring forward tomorrow into today) is deemed to be so critical to the world’s economic system that banks (and many other financial institutions) are deemed to be vital and their survival guaranteed by governments. This has led inexorably to the current sovereign debt crisis in Europe and the ability of senior banking staff to act as monopolistic winners over both the banks’ shareholders and the rest of the economy. As David Kynaston wrote about the reasons for more recent banking excesses : “the most important is the arrival of the insidiously tempting one-way bet.”(David Kynaston – City of London – 2011)

So what (if anything) can be done to change this?

The Threat to the Time Travellers

As Llewellyn’s paper in 1999 suggested (and this was before the banking mayhem of 2008), banks are undergoing major changes that technology (for example) is forcing. Banking (for so long run by insider networks who knew each other and government ministers intimately, went to the same schools and spoke the same language) is now more open to other institutions (whether supermarkets or Virgin) and trading companies are better equipped to tackle the markets directly (corporate bond issues being the main way of doing this).

Yet, traditional banking methods and the banks’ place in the economy (especially in London) feels similar to what it has done for 200 years even if the competition is growing from other institutions and from overseas (Chinese banks – owned and dependent on the Chinese State – especially). Defence of our banks by our government against the newly developing nations financial institutions is one impediment to progress.

This could be a tipping point, though. Money and monetary systems will remain the kratogenic blocks on which economies slide and which cause massive earthquakes from time to time, but the banks’ position within these systems will change. Digitisation and the spread of wealth into the developing nations of China, Brazil and elsewhere will fracture the monopoly position of western banks and the West’s financial institutions. This may well be a good thing as monopolies are inherently massive impediments to improvement and sustainable growth.

A problem is that western economies that are dependent (or believe they are) on their banking system (London and New York especially but Paris and Frankfurt and elsewhere hate the prospect of losing their monopolies) will fight tooth and nail to prevent or at least slow the pace of change.

The other impediment to change is that those who are in charge of the change process – governments – don’t really understand the nature of banking. Tinkering at the edges (whether bonuses or knighthoods) is a waste of effort. Enlarging capital bases and splitting the casino elements of banking (which would be allowed to fail) from the more traditional lending elements of banks is moving to the right lines if (and this is the critical issue) there is an understanding of how this addresses the massive risks that banks are engaged in (and always have been). Many have argued that this splitting (providing only banks which are less susceptible to macroeconomic shocks should be given last resort assistance) is a cornerstone requirement.(Rochet, J-C Macroeconomic Shocks and Banking Supervision – 2008)

The enlarged capital bases and splitting of key activities into Chinese wall separated entities are hints of the crucial risk factors but not the answer in themselves. For risk and uncertainty are two entirely different features. Risk can be assessed, uncertainty cannot – a set of unknown unknowns. Individual bank risk at the micro-economic level may be manageable through higher capital ratios but take all the banks together and does an amalgam of micro-economic management techniques bulk up to a macro-economic solution?

As digitisation and competition (from other corporations and from newly developing countries) grow, it will lead to more opportunities to time travel. Yuan-based promises are no different from $ or € or £. The risks just get higher.

The critical issue is to manage the degree of tomorrow’s future wealth that we are willing to risk having now. Just like burning oil and gas today has a direct impact on our future generations, so monetary time travel can suck in tomorrow’s wealth. Just ask the Greeks (and Portuguese and the 50% of young Spanish without jobs) whether they agree with monetary time travelling – taking too much of the future for consumption now.

This is a hard call. Growth (at least that measured in the altogether faulty way that we measure GDP – quantity not quality) is at the core of our being. Banking has fuelled that core essence. Reducing the scope of banks and other financial institutions to bring tomorrow into today is a huge macro-economic decision that national banks (like the Bank of England) have to take on responsibility for.

National Banks – their role in macro-economic management of the Banking System

This is not just about bank regulation – it is about the how (at a macro-economic level) the risks and uncertainties are managed on a national and on a world-wide basis. Systemic and earth-shattering breaks in the system can only be better managed when international macro-economic indicators are understood and somehow controlled.

Transaction taxes, capital ratios, splitting bank operations are, I repeat, micro-economic devices. Macro-economic devices now need to be devised and international mechanisms established that regularly evaluate the banks’ individual exposure to macroeconomic factors. (Buch, Eickmeier, Prieto – Macroeconomic Factors and Micro-level Bank Risk – 2010). Building a model of this exposure using 21st Century macro-economic modeling techniques and used within an international banking framework, could be the starting point to better management of extreme banking risk.

But, it will take a transformation of international mindsets and international agreements to take 19th Century economic and political models into the 21st Century. Technology has moved on and presented individual banks and financial institutions with the ability to further manipulate economies and left governments in their wake. This needs some rebalancing and governmental management institutions need to be set up to oversee the critical part banks play in our world and to establish the macro-economic monitoring systems that are needed to avoid economic collapse.