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Wednesday, 30 July 2014

Cyprus and the danger of promises

Ethical economy: Cyprus and the danger of promises

Don’t make promises you can’t keep. Wise parents tell small children that, and wary lovers use that command as a taunt. But in the world of finance, unrealistic promises are the norm, and they are too often broken. Depositors in the banks of Cyprus may be learning that lesson.

True, the government of the Mediterranean island may retreat from its first plan, and in any case the accounts are to be taxed, not written down, so the terms of the deposit insurance will be technically kept. And strictly speaking, deposit guarantees are not being breached in the United States and other countries with an inflation rate higher than the interest rate paid on savings accounts, even though that inflation-tax steadily erodes the accounts’ real value. But in fact, governments - both small and suspect like Cyprus, and large and respectable like the United States - have failed the lovers’ test. They have made promises to savers which they either cannot or will not keep.

These trust-breaking governments can resort to the errant lover’s usual excuse: we could not have known what the future would bring. Just as bitter experience somehow invalidates a promise of undying love, an impossible-to-predict avalanche of bad loans might erase the obligations of Cypriot banks and the equally unpredictable financial crisis could exculpate monetary authorities in the United States and elsewhere. Such events, they can say, are like the acts of God which invalidate insurance policies.

Lovers’ quarrels are a delicate matter, but it is not hard to judge the promises made by the Cypriot government. It should have known better. There was nothing like the financial equivalent of an asteroid collision. The authorities could either have kept the banks from expanding wildly without sufficient buffers against losses, or they could have refused to issue an unaffordable guarantee.

States which use inflation and low interest rates to break their promises may be more suave about their promise-breaking, but they are also guilty of a breach of faith. They obey the letter, but violate the spirit of their commitments.

Thoughtful defenders of guarantees argue that virtuous intentions justify falsehood. Modern economies rely on credit, credit relies on trust, and the economy suffers if mistrustful savers refuse to lend. Besides, disingenuous savings guarantees are hardly an anomaly in the financial system. On the contrary, loans, the standard financial instrument, rely on a similar ethical legerdemain. Promises of future payments are never certain and are often made lightly, for example by junk-rated corporations or by mortgagees before the U.S. housing crisis.

Even though both lenders and borrowers theoretically know roughly how little the promises are worth, strong words, like lovers’ oaths, can be dangerously beguiling. If financial commitments receive too much credence, lenders can sell off their loans at too high a price and borrowers can get away with implausible commitments.

When the truth is finally revealed, financial institutions or entire financial systems may fail - it has happened in the United States, Japan, the UK and several member states of the euro zone within the last generation. The damage from revealing the initial deceit is ultimately greater than the pain of telling the truth in the first place.

What should be done?

First, educate people about the nature of banking. The public is generally unaware that banks take risks with their money. There is a widespread belief that it is right and just to guarantee the value of all deposits. It is actually impossible and dangerous. If more people understood that there is no way to make the future certain, they would be less prone to panic at bad news, and the financial system could be made to conform more closely to economic reality.

Second, make fewer financial promises. Guarantees may bring savings out from under the mattress, but dishonesty is ultimately self-destructive. Every debt promise which is broken - either directly by not paying out or indirectly through inflation - makes the financial system more untrustworthy. The poor may deserve some protection - perhaps a guarantee for the real value of the first few thousand dollars or euros of savings - but everyone else should have to take more chances.

Finally, phase out conventional debt. The apparent certainty of loans with fixed terms and fixed nominal interest is misleading, even false, since unpredictable and varying rates of inflation and GDP growth ensure that their true value is uncertain. Such loans should mostly be replaced by common shares, which conform better to economic reality. Of course, governments cannot issue shares, but their debts can be made more like equity, linked to inflation and GDP growth.

The world has still not recovered from the 2008 financial crisis, in large part because the financial system has lost credibility. That will not be regained fully until finance is no longer based on impossible promises.

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