What the Cyprus case tells us

In order to understand the current problems in Cyprus, it is first necessary to know how the mess arose in the first place. Reuters have a very good background article here, and I will use it extensively. The 'series of events' that led up to the crisis commences with Cyprus joining the Euro zone:

Before joining the euro, the Central Bank of Cyprus only allowed banks to use up to 30 percent of their foreign deposits to support local lending, a measure designed to prevent sizeable deposits from Greeks and Russians fuelling a bubble.

When Cyprus joined the single European currency, Greek and other euro area deposits were reclassified as domestic, leading to billions more local lending, Pambos Papageorgiou, a member of Cyprus's parliament and a former central bank board member said.

Following the 2008 crisis, this conservative reputation was to lead to money flowing into the banks in Cyprus as a 'safe haven'. The problem was that the money arriving has nowhere productive to go, so mirroring what had taken place in other economies (e.g. the US), the money ended up in real estate, fuelling a bubble in real estate prices. However, this flow of money could not all be absorbed in real estate, with the Cyprus banks growing at a rate totally divorced from the wider economy. Due to historical ties, the destination of choice for the inward flow of money was an outwards flow towards Greece:

The EBA figures showed 30 percent (11 billion euros) of Bank of Cyprus' total loan book was wrapped up in Greece by December 2010, as was 43 percent (or 19 billion euros) of Laiki's, which was then known as Marfin Popular.

More striking was the bank's exposure to Greek debt.

At the time, Bank of Cyprus's 2.4 billion euros of Greek debt was enough to wipe out 75 percent of the bank's total capital, while Laiki's 3.4 billion euros exposure outstripped its 3.2 billion euros of total capital.

There is considerable more detail that could be added, such as the high returns offered by Cypriot banks, but also underlying the high risk speculation is a finger pointing at lax regulation by the central bank:

Whatever the motive, the Greek exposure defied country risk standards typically applied by central banks; a clause in Cyprus' EU/IMF December memorandum of understanding explicitly requires the banks to have more diversified portfolios of higher credit quality.

"That (the way the exposures were allowed to build) was a problem of supervision," said Papageorgiou, who was a member of the six-man board of directors of the central bank at the time.
The board, which met less than once a month, never knew how much Greek debt the banks were holding, both Papageorgiou and another person with direct knowledge of the situation told Reuters.

It seems that, when reflecting on the lead up to the current mess, the factors that drove the crisis forwards are oddly familiar. If looking at the US crisis, floods of money were pouring into the US in the lead up to the crisis, with that money over-spilling into the real estate market, and thus causing a bubble. Just as in the US, the central bank was happy as long as everyone seemed to be getting richer. In both cases, it was a flood of overseas money entering the economy that underpinned the problems (e.g. see here). 

There is an important point in this story, and it a point that does not receive enough attention. There is a widespread misconception that the politicians and policy makers are in control of their own economies. However, this is a myth. They may have influence on their own economy, but they do not control it. The problems in Cyprus are derived from excessive capital flows, and just as happened in the US, when faced with a wall of money, the Cypriot banks were not going to turn it away, but find a home for it. Thus there is a real estate boom, and this will then drive the Cyprus economy into apparent growth, as ever more money chases a limited supply of real estate, and paper gains in value of real estate create economic growth, without any real underlying increase in the output of the economy. Instead, the increase in output is simply the result of excess credit appearing in the economy.

The difference in the Cypriot and US examples is that the small size of the economy serves to exagerate the same effect. When the Fed acts, it is acting on an economy which is relatively large in relation to the flows of capital throughout the world, so is more influential. In the case of a small economy like Cyprus, the actions of policy makers are swamped by the influence of that same capital. Similarly, the US real estate market was so large, that it was able to absorb a large amount of capital. In other words, it is a similar process that took place, but with differences in degree of effect. We can see a similar process taking effect in other economies. For example, in New Zealand (population about 6 million), the central bank labours under the illusion that it has some control over the New Zealand economy through interest rates targets.

The New Zealand dollar tumbled almost a cent against the US dollar after the Reserve Bank said interest rates will remain at a record low through this year. 

The bank also hinted at a cut to the official cash rate if the currency was higher than justified by economic fundamentals.

The kiwi fell to 81.66 US cents from 82.60 cents immediately before the statement.

This is the interesting point:

Local property prices rose 7.6 percent last month on increasing sales numbers, according to Real Estate Institute figures. New Zealand's property market gains have been driven by a lack of supply in its biggest city, Auckland, and as the Canterbury rebuild gets underway.

"House price inflation is increasing and the bank does not want to see financial stability or inflation risks accentuated by housing demand getting too far ahead of supply," Mr Wheeler says.
The Reserve Bank estimates house prices increased in real terms at an annual pace of 6 percent last year, and will rise 6.2 percent and 3.6 percent this year and the next.

Although following an earthquake there is a genuine supply problem, this is not the real driver of the real estate market. You will notice that the interest rates are relatively high in comparison with other Western economies. The chart and quote below come from the New Zealand Reserve Bank:

The US Dollar cross rate should be interpreted as one New Zealand dollar buying x US dollars. The TWI (Trade-weighted index) is the nominal NZ dollar exchange rate weighted 50/50 by New Zealand's trade with its major trading partners and the nominal GDPs (in US dollars) of those countries. The graph shows monthly averages.

In October 2000 the New Zealand dollar reached record lows, dropping below 40 cents per NZD. However, after 2002, the currency strengthened considerably, reflecting a strong domestic economy, rising export commodity prices and associated increases in interest rates. The TWI behaved very similarly to the US dollar cross rate over most of the decade .

In 2008, continuing financial market uncertainties and a deteriorating global economic outlook saw many investors move into perceived 'safe-haven' currencies such as the USD. As a result the NZD fell sharply against the USD and other currencies in the TWI (the Japanese Yen and Euro in particular), but these falls proved to be quite shortlived. In part that reflected the way in which New Zealand was hit less hard in the recession than many of the countries whose currencies make up the TWI.

 

In a small economy like New Zealand, here is the problem. They currently have what looks like a real estate bubble.

The country's average salary of $45,000 was more than double that of many lower-income families who struggled to pay rent, Mr Evans said.

"Once you've paid rent and power bills and put petrol in the car so you can get to work, there's not much left over for food."

And then we have this:

The New Zealand property market rebounded from the seasonal lull in listings over the summer break with 13,145 new listings coming to the market in February. Auckland saw its average asking price exceed $600,000 for the third time, while Canterbury’s figure surpassed $400,000, for the fourth time.

It is very clear that the underlying driver of house prices is not wages, as there is a mismatch between income and house prices. Although there may be some supply issues within the house prices (in particular in Christchurch), this would not explain this disconnect between salary and house price. The real driver is that there is an oversupply of credit into the market. To put this simply, if there is 100 units of credit chasing 100 units, and then we increase the supply of credit to 130 units without changing the supply of units, then we will see the cost of each unit increase. Note, nothing has changed in the quality of the units; just by increasing supply of credit is sufficient to increase prices. 

This is why the central bank is not in control. For those unfamiliar with the idea of the carry trade, it works like this. I borrow extremely cheaply in the US with effective 0% interest rates, and then lend that same money into another economy with higher interest rates. I take a risk on the currency in so doing, but the rewards are potentially very high. Even better, if lots of people are doing the same thing as me, the demand for $NZ is increasing and this leads to currency appreciation. Even better, the new money entering the economy creates a positive uptick in the New Zealand economy, and this further strengthens the currency. This is exactly what is taking place in New Zealand now:

The economy grew faster than expected through the tail end of last year, underpinned by the Canterbury rebuild, and that stronger domestic demand is seen as creating medium-term inflationary pressures, even as consumer prices remain subdued in the foreseeable future, the bank says in the monetary policy statement.

"Monetary policy settings must balance this low near-term inflation outlook and concerns about the exchange rate and weak labour market, against increasing signs that output will accelerate and inflationary pressures will pick up."

New Zealand food prices fell 0.3 percent last month, led by seasonally cheaper fruit and vegetables and discounted meat, according to government figures published yesterday.

Food prices account for about 19 percent of the consumer price index, which was tracking below the central bank's target 1 percent to 3 percent band in the December quarter at 0.9 percent.

The bank sees the annual pace of inflation staying at 0.9 percent until the September quarter this year, rising the mid-point of its band in latter half of 2015. Medium-term pressures are expected to come in the housing and construction sectors, with the risks skewed to the upside, it said.

Again, the Christchurch rebuild is undoubtedly a factor, but so is the entry of new credit into the economy. Note that inflation is subdued. If you have currency appreciation, imports become cheaper, and this will help keep inflation in check.

Into this interesting bubble scenario, we have the role of the central bank. The brief fall in the $NZ was probably due to previous speculation that the interest rate would be raised to tame the house price bubble. However, had the central bank increased interest rates, the impact would have been to make New Zealand even more attractive to the carry trade, and thus have the opposite effect to the one intended. The problem is that, in keeping a low interest rate target, there is nothing to pop the bubble in house prices. In other words, until such time as the carry trade winds down, there is nothing that the central bank can do which will tame the house price bubble, with the associated problems that will develop from the bubble.

In other words, the New Zealand economy is in the hands of others. For example, if a large economy such as the US targets 0% interest, this will lead to carry trade activity, and this will impact on other economies such as New Zealand. Whether New Zealand is a carry trade destination is determined by New Zealand interest rates, but they are determined by factors such as the currency, and the current levels of credit entering the economy. Most importantly, there is the speculation of the capital markets, based upon exchange rate risk, and the exchange rate risk is determined in part by the speculation, and this is divorced from the underlying economy of New Zealand, as their own collective actions are determining the value of the currency. For the carry trade, it is all about timing. Getting in early, and getting out before it unwinds is the key. The more new entrants into the carry trade, the higher the currency appreciation, the more profit to be made. However, the credit creates an artificial boom in the economy, which can rapidly turn to bust as credit based growth starts to reach saturation, and the situation unwinds, including currency depreciation. The carry trader needs to get out before this takes place.

Returning to Cyprus, the key difference is that Cyprus is a Euro economy which meant that, in consideration of the size of Cyprus, the state of the economy had no influence whatsoever on the value of the currency. This disassociation between the underlying economy and the currency, and the wall of money being thrown at the economy, means that there was no currency derived time 'to get out' excepting where the Euro area was perceived to be at risk. This and the reputation for being conservative but providing outsize returns, made Cyprus an attractive destination. The key to the outsized returns was, in turn, the result of lax bank regulation. Regulation gave an illusion of stability, but it was no more than this; an illusion. Cyprus had only one means to control the situation, which was central bank regulation. However, just as with the many cases in recent history, when a flood of money enters into an economy, the economy booms, the regulators always seem to look the other way. Whilst things are 'good', they suddenly freeze, and fail to act. We have now seen this so many times that it is becoming sadly comedic. However, the illusion that all is okay due to regulation always remains, and ultimately contributes significantly to the growth of the problem.

However, one element of the Cyprus problem was not derived from central bank regulation, which was the property bubble. It has yet to unwind fully. However, we can see it time and time again; when a flood of money arrives in an economy, with nowhere productive to go, real estate is the destination of choice. This in turn creates a boom, and a boom that, in the end is unsustainable, being derived not from underlying economic growth, but in increased consumption. As Krugman (goodness, am I referencing Krugman?) points out, this led to a 15% of GDP current account deficit in 2008:

Is this all sounding all too familiar? It should be, because what we are seeing is an exaggerated picture of the reality of many economies. I will pick out the key points:

1. Banking regulators; they fail, fail, fail and fail time and time again when it matters
2. Policy makers only have limited influence on an economy, and the degree of that influence is often far less than is perceived. The size of the economy in relation to capital markets determines the influence.
3. Carry trade bubbles are self-reinforcing, and even more so when removed from currency risk
4. Real estate bubbles are economic weapons of mass destruction, and appear to be primarily derived from carry trade activity
5. Developing an oversize financial services industry is fatal. 

With regards to point (2), even though the US economy is huge, we can see the carry trade undermining the policy of the central bank. As fast as new money is pumped into the economy, it leaks out through carry trade activity and creates mayhem in other economies.  A long time ago (January, 2010) I discussed 'the Masters of the Universe' who suffered the illusion of control over their economies:

What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

One of the points that I made all that time ago was that the US crisis that emerged in 2008 was, in part, derived from the Japanese Yen carry trade, which was driven by the Japanese bank printing money. When we look at small economies, such as New Zealand and Cyprus, we can see the policy spill-over from other countries more clearly. Whilst there are some very clear differenced between the two economies, they share a single common characteristic; the policy makers are not in control. Furthermore, it is apparent that, as I long ago suggested, policy makers are resorting to ever more dramatic policies (e.g. QE Infinity in the US), and we will no doubt see this generate even greater instabilities in the global economy, and also in the lever pulling countries. It leaves us with the troubling question of how the global economy might look as these ever more extreme policies generate yet more extreme policy in response? It is a worrying question, but those 'in control' of policy have yet to even recognise their own position in the world economy, let alone think through the answer to this question.

Note: Thank you Lemming for the comment that prompted this post. Please accept my apologies for not posting, but I have been working 7 days a week again, and could not face more time in front of the computer. I will try to post more regularly, but my work is consuming me at present.

Note 2: I did think about commenting on the 'haircut' policy, but thought that the question of lack of control was more interesting. I hope you agree.

The Cigarette Lighter Problem

I have mainly been talking about the UK economy, but for a moment I would like to talk about the 'cigarette lighter problem'. It is a rather unusual way of looking at the underlying functioning of economies that I came up with when discussing economics with some friends.

The starting point is my purchase of a disposable lighter in China for approximately $NZ 0.19. I purchased an equivalent lighter in New Zealand for $NZ 1.80. In both cases I purchased the lighter in small shops. In both cases the lighters were equivalent products, and the convenience of the shops were identical, and the service provided identical. In both cases the lighters were manufactured in China.

The problem arises as to why the prices were so different.

At this point it is very tempting to get into discussions about purchasing power parity, but I am going to put that to one side and consider the real implications. The problem here is that, for some reason, the lighter in New Zealand is about 9 times more expensive.

Before continuing it is necessary to remove one factor in the consideration of the price; the cost of transport of the lighter from China to New Zealand. When we think of the size of lighter, and the cost of shipping, it will be apparent that the cost of shipping is going to add virtually nothing to the cost of the lighter.

So where does this additional cost come from? It is first necessary to track the journey of a lighter through the distribution systems until it reaches my hand.

In both cases, once the lighter has been manufactured, the journey of the lighter to a corner shop will start in a warehouse. Someone will be selling the lighter to wholesale. When the wholesaler purchases the lighter it will be transported from this warehouse to the wholesalers warehouse. The wholesaler will be providing an aggregation service to small shops, providing a range of products to service the small shop sector. The small shop will then purchase the lighter, along with other lighters and other products stocked by the wholesaler. There are then 2 options here. One is that the wholesaler will deliver, or the other is that the purchaser will be purchasing from a 'Cash and Carry' type wholesaler, such that the owners transport the lighter to the shop themselves. Using either method, there should be no significant cost differential. In both cases the shop owner took the lighter out of the packaging and onto a shelf. In both cases the shop owner took the lighter off the shelf and placed it in my hand, before accepting my payment.

When we look at this process, we have to ask ourselves where exactly is NZ 1.60 (approx.) of added value coming from? When we view this process this way, we see that near identical systems of distribution of exactly the same product and service, result in a massive price differential. Is there any added value in the process whatsoever?

The answer, of course, is 'no'.

So why does this matter? If we then think of any economic activity whatsoever in New Zealand (or any other OECD economy), we have to factor in the fact that, whatever activity occurs, this kind of cost escalation is going to be built into the activity. The result of this is that the overall economic activity of the economy overall must generate massive added value to support such cost escalations. For example, manufacturing of products, and the provision of services must be creating huge amounts of value in order for a system of such cost escalation to be supported.

So why does the lighter cost more in New Zealand? The key difference in the process of distribution of the lighter is not in any added value, but in the cost of wages, and the cost of government through taxes and regulation, the cost of warehousing through higher land costs.

In order to support such additional costs, the economy must have elements that are creating wealth for redistribution on a massive scale.

The question to then ask is; where is such wealth generating capacity in the New Zealand economy. The same question can be asked of the U.S. or the U.K. and so on.... Having asked this question, the size of the problem becomes apparent. In the case of the lighter, the cost of the lighter is nine times the cost in China. How can an economy be generating enough added value to sustain these kind of differentials?

I am aware that a lighter is just one example, and not all products have the same differential. However, the point remains. How can the OECD economies justify, and continue to justify, such massive differentials of cost without creating massive added value in other areas of the economy. When we think of the real economy, and compare this with China, where is such massive added value taking place? China increasingly has similar manufacturing industries, service industries, distribution and so on. Despite this, they are able to sell a lighter nine times cheaper than in New Zealand.

It raises the possibility that something is very wrong and unbalanced in the world economy. The question this raises is how big is the imbalance, and how will it be corrected? My own view is that we are just now starting to see the correction, and are just now starting to see the pain of the correction.

Note added 30 Jan 2009:

I have had a very good comment on this post, which was added to another post. As such, I thought I would add the comment here, along with my response.

This is the comment from Aantonikl:

I'm not convinced that we are "much poorer than we think". Your cigarette lighter argument shows that exchanges rates are out of line with purchasing power parity, but that is unrelated to how poor we are. In china, the minimum monthly wage is in urban areas somewhere about 800 RMB a month http://www.marketwatch.com/news/story/china-raises-minimum-wages-calm/story.aspx?guid={B120D814-3C01-468A-9C11-B7596BCE1A35}
This ignores the rural population. But the rural population do not count towards the increase in global labour. Thus in china, on the minimum wage I can buy (according to your figures) 1150 lighters.

In the uk the monthly median wage is about 2075 pounds (http://www.statistics.gov.uk/cci/nugget.asp?id=285), and the relation between the minimum and median wage is about .45 in the uk (http://stats.oecd.org/wbos/Index.aspx?DataSetCode=MIN2MED)
Thus in the UK, someone on the minimum wage will earn about 900 pounds a month. Lighters are .59 pounds (http://www.sainsburys.com/groceries/index.jsp?bmUID=1233139730826)
So I could buy 1500 lighters.

So, the difference in what labour buys between the UK and China is not so great, especially since I suspect they work longer per month in China than the UK. Our cheap labour is worth about the same. For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.

So whilst the world economy is in big trouble, and things are going to change, I'm not convinced the man is the western street is suddenly going to be poorer. He may have to change job, and move to an industry that produces more value, but what his labour will buy him should stay the same.

My response was as follows:

Aantonikl:

Thank you for an excellent and very well thought out response to the 'Cigarette Lighter Problem.'

For other readers, the original post can be found here:

http://cynicuseconomicus.blogspot.com/2008/06/cigarette-lighter-problem.html


Your point about the rural population in China is interesting, but we have an equivalent in the long term unemployed. The difference perhaps is that one group is self-sufficient, the other is not. In fact the latter group in the UK could be described as the minimimum wage?

Your analysis reminds me of something I read recently on measuring salary in terms of Mars bars purchasing power - which showed that there was very little real change in the salary of new graduate starting salary at ICI from (I think) 1950 and now.i.e. you can buy roughly the same number of Mars bars now as then with the salary.

Essentially the Mars bar comparison highlights that the measure of inflation is very dubious.

However, returning to your excellent analysis. I am not sure that you have followed it through to the logical conclusion.

You correctly identify that exchange rates are out of line with PPP. In this case I could change £1 and buy several lighters if I took that money into a Chinese shop.

This has been one of the consistent arguments of this blog. Exchange rates are going to have to shift.

You suggest that is that there is not much difference in the value created by our cheap labour and that of China, so we will not be poorer in the future. However, it is evident from your own argument that our purchasing power is being significantly subsidised by China (and I would add - many others).

The imbalance in the exchange rates means that we have not been paying the full value for the goods that we purchase. We have had our purchasing subsidised by China.

If we take away that subsidy (exchange rate corrects), then our purchasing power will diminish significantly. This, by any reasonable definition, means that we will be poorer. At its most simple, the lighter we bought for 59p will go up in price.

One point of contention. You use the price from a major UK supermarket for a comparison. However, in my comparison I used a New Zealand dairy (corner shop/convenience store) and an equivalent sized shop in China.

I do not remember/know what a lighter would cost in a supermarket in China (e.g. there was a Walmart near where I lived in China), but would guess that the price would be considerably lower than that which you used.

Another point of contention is your assertion that:

'For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.'

I think that you are making some very bold assertions here. For example, infrastructure in China (in the cities, but also increasingly so in the countryside) is surprisingly good, whether transport, power, or telecoms. Clean water still leaves a lot to be desired, but that is about it.

Your other example is lack of rule of law, which is true, but the lack of rule of law in China has advantages. For example, they can use our intellectual property without paying for it. The absence of law is also a positive in that regulation is less, and often can be ignored, such that costs of regulatory compliance are lower, and so forth.

The cost of this lack of law is uncertainty and corruption, and lack of incentive to develop intellectual property (IP). However, as soon as the balance is to the advantage to China to enforce IP rights, you can be sure that the rule of law will (as if by magic) be enforced.

I think overall you are making some assumptions in your proposed advantages, at least in the examples you cite. If you were to visit a Chinese city/live in China, you may be very surprised, and the same might be said of many of the towns, in particular in the most developed provinces (e.g. Guangdong).

Finally, there is the most fundamental problem. If we accept that our economy has been supported by borrowing, one of the central themes of this blog, then the problem becomes worrying.

In particular, borrowed money circulates through the economy, pushing up activity, pushing up employment, and so forth. All of this offers a higher standard of living for everyone (in the short term)and this reflects in the cost of everything.

As such, every part of the economy appears to have greater wealth than really is the case. For example, the borrowed money is supporting higher wages through higher employment levels.

As such, if you think about it, just taking the case of wages as an example of a factor, those higher wages impact upon the selling price of that lighter. Many people are involved in finally putting that lighter on the shelf, though their overall % contribution to the price will not be that large.

However, this is just one factor, but another might be the cost of real estate, and so forth...the cumulative impact of the higher costs finally ends up in the lighter.

Returning to wages, the cost of the lighter is higher to support the higher wages, and the higher wages are partly resultant from the artificial boom in the economy. The artificial boom is the result of borrowing.

What we have, therefore, is a situation where a part of the price of the lighter originates in borrowed money. As a purchaser, I am also in part spending borrowed money, even if I am buying it from my wages, for the same reason as I have just explained for the cost of the lighter. In other words, part of the transaction is financed by economy wide borrowing.

This is difficult to grasp, I know, but when I buy a lighter with cash (not borrowing), I am in reality using partly borrowed money to purchase the lighter, and the price of the lighter is higher than it should be because of borrowed money.

However, thank you for an excellent and well thought out comment. At some point I may copy your comment and this reply to the original post.

I will welcome a response to my reply. In particular if you feel that you still disagree with my assertion that we are poorer than we think.

More comments are welcomed.