By: John Mauldin

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.

– John Mills, “On Credit Cycles and the Origin of Commercial Panics,” 1867

Hyman Minsky developed an economics of financial instability, of instability bred by stability itself…. Minsky’s approach, very different from Godley’s, is conceptual rather than statistical. A key virtue is that it puts finance at the center of economic analysis, analytically inseparable from what is sometimes called real economic activity, for the simple reason that capitalistic economies are run by banks.

To grasp what Minsky is about, it seems to me, is to go immediately beyond the coarse notion of the ‘Minsky moment,’ a concept which implies falsely that there are also non-Minsky moments. It is to recognize that the financial system is both necessary and dangerous, that strict financial regulation is both indispensable and imperfect.

– James Galbraith, 5th annual Dijon conference on post-Keynesian economics, Copenhagen, May 2011

I find myself finishing this letter on an island off the coast of Croatia, on the backside of the middle of nowhere. But it is the perfect place to contemplate my recent experience in Cyprus. Through the efforts of your fellow readers, I was able to meet a wide variety of people and have some in-depth discussions on the crisis that has enveloped Cyprus. And while the details are different, of course, there is a pattern to the weave, so to speak, that calls to mind various aspects of the crisis that began in 2008. And perhaps that pattern will give us a glimpse of what else may be coming our way.

You must first realize that Cyprus is a very small country, some 800,000 people. Among the leadership, everyone knows everyone. There is much to admire, as we will see. But Cyprus has had a gut-wrenching crisis, proportionately more dire than any in other European countries recently; and precedents are being established here for how future problems will be dealt with in the Eurozone and elsewhere.

To start a two-day marathon of meetings, I sat down Tuesday morning with two brothers, Symeon and Andreas Matsis. Symeon was until a few weeks ago a board member of the Bank of Cyprus, the largest bank on the island and now the focus of the financial crisis. He made his career in the governmental sector, where he was the general manager of the Planning Bureau of the Ministry of Finance. Andreas Matsis is a local businessman who until a few weeks ago sat on the board of the Central Bank of Cyprus. He is a successful entrepreneur who was also until recently the president of one of the local chambers of commerce. They are both in their early 70s, soft-spoken and totally engaging and forthcoming. Our one-hour meeting stretched to two hours.

Symeon carried a copy of This Time Is Different by Rogoff and Reinhart. It was dog-eared and full of notes. “I am reading it so I can try to understand what happened to us. The more I read the more I understand that they were describing Cyprus. And we did think that ‘This country is different.’ Which is why the crisis has been such a shock to our local culture.”

And such a shock. The next evening, I dined with a group of families, eating the local version of Greek cuisine, course after course after course. While they were all severely financially distressed, to a person they believed that Cyprus would come back, and they offered reasons why one should still do business is Cyprus. They were not sure what they would do, as their livelihoods were in danger, yet they faced the future with the strong resolve to figure it out. “Our parents lost everything in 1974 (when Turkey invaded the north portion of the island) and then came here and built a good new life. We can do this.”

One of the women at dinner was a charming lady who had retired in January after a career at the Bank of Cyprus. Note this was less than three months before the crisis in mid-March. She had her entire pension and life savings in the Bank of Cyprus, which she totally trusted. And now it looks like she will lose at least 60% of those savings. It could have been worse. She could have been at Laiki Bank. There the losses may be 100%.

The country has instituted capital controls, and she has access to only about 10% of her savings. At some point she will get all the remaining money but cannot move it out of the country until the capital controls are released.

“If you could get it today, would you leave it in the bank?” I asked.

She looked down and said quietly, “No, I would have to move it. I have children that will need that money for going to college abroad and then for help in buying homes. I can’t take the risk that the money will not be there.”

She pointed to one of the unique and positive features of Cyprus. Until recently, there was no university on the island. Everyone went abroad to college, typically then staying on in the country where they were educated and getting work experience before returning with skills and contacts. Cyprus is a country of accountants and lawyers, engineers, and other professionals.

The Bank of Cyprus made about 40% of the loans extended to businesses in Cyprus. It is now out of business itself. There are some solvent banks with available funds, but they can’t make loans, because if capital controls are lifted, it is likely that a significant number of Cypriots would, like the lady mentioned above, move their money. There’s no question that money will fly out of the country if trust is not first restored. But with no available bank financing, in addition to capital controls, businesses are closing up left and right. Unemployment, which was basically unknown before, now stands at 15% and is likely to go to 20%. If there is no functioning banking system for new loans, that makes doing business very difficult; and buying and selling property, outside of the cash market, is at a standstill.

But which will arrive first? Trust and a new beginning or capital flight and a long nightmare? It is a chicken and egg sort of problem with no easy answer, and one which I will attempt to bring some thought to later.

“This Country Is Different”

But to in order to delve further into this conversation about Cyprus, we are first going to return to France. Last week I wrote from France, where I suggested that France was on its way to becoming the next Greece. I got a very impassioned letter from a French citizen who made the case that France is not Greece. “As a Frenchman I am more than used to this mainstream French bashing, and I hoped from such an article to read about new facts or data.” And he made one point on which I need to allow him to correct me:

You say, “French President F. Hollande is worsening the situation by undoing what Sarkozy did well (putting back the retirement age from 62 to 60).” Not true. The legal age for retirement in France is still 62; FH did not change that. Had you looked a bit deeper into the details you would have understood that he only made a minor adjustment for the people who started working very early in life. The cost of this was nearly €200 million (1% of the 2020 estimated deficit of the pension system). And … the French government is currently working on a reform to balance the pension budget by 2020. The first pension reform by a socialist government ever…

He then went on to list the ways that France is not Greece. And if you take them at face value, there are indeed many ways that France is not Greece. And neither is France Spain; nor is it Italy, Ireland, Portugal, or … Cyprus. Yet all these Eurozone nations do share similar problems. What the writer basically maintains is that France is somehow different – that its circumstances are different and that the government is in some way more serious.

But serious about what? My friend Kiron Sarkar notes today:

The French auditor, the Cour des Comptes, states that France has only “a small chance” of meeting its revised budget target of 3.7% of GDP this year and will have to cut back on spending. Furthermore, they added that the extended deadline of 2015 to reduce debt to GDP to 3.0% would require France making a “big effort”. There is a chance that the French economy would contract this year, they reported. The current administration in France is not going to cut back. I just can’t see how France and/or the EZ deals with these issues. Today, French June consumer confidence came in at 78 M/M, lower than the 81 expected and the 79 in May.”

It is not the differences that are at issue, it is the similarities. And at the root of the Eurozone crisis is too much debt. Too much bank debt. Too much sovereign debt. Too much bad debt.

The quote from John Mills at the beginning of the letter returns to mind:

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.

The most important book on the topic of the problems that have come to the fore in the last decade is clearly Rogoff’s and Reinhart’s brilliant tome, This Time Is Different, which examines 260+ financial crises over the last few centuries. While each is different in the particulars, they all have at their root too much debt and insolvent governments and/or banks. There is not some magic number that shouts, “Too much. This far and no further!” but the fundamental issue is clear.

The BANG! Moment comes, say R&R, when a wary bond market refuses to buy debt at a price that is financially sustainable for the debtor. In that moment, confidence and trust are lost. Can France pull back from that precipice? Surely. Nothing is hopeless, and my French correspondent is no less hopeful that his mother country, France, will avoid a crisis than I am hopeful about the US. Somehow, I must confess, I really do think that the US is different and will see the warning lights and pull back from the brink. At the same time, I squirrel away a little gold every month, just in case. I guess at the end of the day I truly don’t trust the bastards. (By the way, I am happy to see the gold price drop, because that means I get more pieces of gold for my pieces of paper. But then, I am not buying gold as an investment but as central bank insurance. I like it when my insurance premiums go down.)

So what can Cyprus teach us? Many things actually. First, as Symeon said, they truly believed that “This country is different.” And for good reasons.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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