We could have seen this coming. Or couldn't we?

A Black Swan in "Petra tou Romiou" in Cyprus. Photo by XristonPn

The handling of Cyprus's troubles will go down as one of the worst in economic history. Not only is one systemic bank forced to liquidation but the other has been treated as such (and will probably end up as such) since the infamous Eurogroup announcement on March 16th. Then, as the world was trying to accept the results, many began defending the handling of the situation, calling it necessary, moral and fair.

The basic premise of the "defense" is that people should have seen this coming and take the appropriate measures to counter it. Yet, what all of them fail to see is that nobody had ever warned about such things before. The most notable article on this was Peter Spiegel's one concerning a confidential memorandum on a haircut which would be "involving more foreign depositors and bond holders". Yet, this was not the outcome of some economic or political forecast of any kind. This was the result of a journalist doing his job (and doing it very well), at a time where nobody expected such decisions. There were some other articles which appeared in the press by the time the Eurogroup decision had been reached but these were the whole deal: a debate by Charles Goodhart of LSE arguing against bail-ins, an article in Bruegel which compared the similarities between a Cyprus and a Danish bail-in, a Reuters article presenting the possibilities for the Eurogroup meeting, another SSRN paper proposing measures to prevent such a bail-in, one on the NYT questioning whether such proposals might actually be feasible and one by yours truly explaining why a deposits haircut was a terrible idea. Note that the earliest of this articles (the NYT one) was just published on January 10th, with all the rest (except the SSRN paper which was again in late January) published a couple of days before the haircut.

Again, this was not the result of any economic analysis which predicted such an outcome. At most, it was an examination of what might happen, based on media reports which were more volatile than most speculative trades. Any person who calls himself an investor would not dare decide on such information, much less a depositor who has almost no idea what to do even if he understands this information, especially if most of his money are already tied up in time deposits. In all the aforementioned articles (other than the Peter Spiegel one), nothing specific on who would participate in such a haircut appeared. (Just notice the difference between the two Eurogroup decisions: the first was a levy on all depositors in all banks while the second was a levy on uninsured depositors in the two large banks). What happened next was what Nassim Nicolas Taleb would describe as a Black Swan: 

1. The event is a surprise (to the observer).
2. The event has a major effect.
3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.

We cannot fully understand the effects of the decision on Cyprus yet, thus although point 2 may be out of our reach at the moment, yet, point 3 is what we should be focusing on. A notable example is Jean Pisani-Ferry who stated the following after the first Eurogroup decision was made:

All those who say Cyprus tax is robbery, have a look. No reward w/out risk. Savers could have deposited in Germany.bit.ly/15aaw7v
— Jean Pisani-Ferry (@BruegelPisani) March 16, 2013

The link provides a summary of the accounts a Russian bank was (is?) providing in Cyprus, with their respective interest rates. Yet, it appears that no earlier statements had been made on Cyprus, either warning about the eminent collapse or of the increasing interest rates, which by the way were always high even before Cyprus's entry in the EU or the Eurozone. As for the seriousness of the argument that savers should have deposited in Germany it appears that although there may be many pensioners with more than €100,000 in a bank (which may be nothing more than saving €100 per month for several years), the idea of sending their money abroad is almost incomprehensible if they never had a background in investments and especially if they use that money in their everyday lives, or they are tied in time deposits.

People have taken the chain of events in Cyprus even further as Barnejek now proposes that abolishing deposit insurance would be good for the bank health. Again, we have a failure to understand what we can forecast and what we cannot. In a discussion after my asking what we should do if a similar crisis occurred in the 2030's and we had no deposit insurance the argument was that we shouldn't worry about a future crisis. Abolishing deposit insurance would supposedly make banks stronger and people would be more careful on their choice of bank. Nevertheless, I would like to remind the reader that we tend to forget fast and the "this time it's different" motto will be heard again when the economy is booming. Who would be willing to go through 200+ pages of annual reports to understand whether a bank is good or not or even if one would be willing to do so how many of us have what it takes to really see through these? If we all could then Warren Buffett wouldn't be the only billionaire investor.

Then, the argument about making banks stronger would perhaps hold for some time after the recession, although it is the case that banks have very strong balance sheets when the economy shifts from recession to growth (Minksy had mentioned this back in the 1980's on what he called the financial instability hypothesis). Then as times are good, banks fund more loans of less and less quality, resulting in trouble again (again, Minsky is the originator of these theories). Then, when it hits the fan, and they lose money or are at the brink of doing so, people start paying attention to what their bank had been doing before and complain that we should have seen this before (just remember the Madoff scheme which lasted more than 40 years-in which case people could actually foresee trouble.). If we have no deposit insurance then as soon as news of financial distress hit the market (regardless of being justified or not) a bank run will occur destroying the bank through a huge outflow of liquidity. Thus, if (or after) trust is replaced by suspicion, any rumour that a bank is not financially well will in fact destroy it. A better alternative, the creation of a fund similar to the FDIC, has not promoted thus far. (Roger Lowenstein provides a short history of the Deposits Insurance Scheme in the US here).

In addition to the above, it has been suggested that the bail-in wasn't something new and if we kept our eyes open we could have seen it in a 2010 proposal. Well, first of all, a proposal for a directive is not the same as a directive. Just because 1 million Americans asked for the construction of a Death Star does not mean they are going to get it. If the documents which leaked 2-3 weeks before the event were classified as confidential then how was that public information? There was an outflow of deposits from the Cypriot banking system yet, this was more out of concern and reaction to rumours (which also proves the point made in the previous paragraph) than of predicting the outcome.

In retrospect everything appears to be easy, yet were where the voices of concern from Cypriot authorities when the Bank of Cyprus or Laiki Bank invested in Greek bonds? How about from Bundesbank officials when German banks did the same? (Yes, German banks got rid of much of those bonds later although it is doubtful whether this was done through BuBa pressure) As a former member of the BoC board states the decision to invest in them was considered good and profitable for the bank at the time. It would be unrealistic to believe that directors (and especially the CEO) of a bank would choose a terrible investment on purpose as this is not to their best personal interest: the bonuses they received were based on bank performance meaning that if the bank was doing bad then they received nothing. Nevertheless, it would also be unrealistic to assume that these choices were not terrible or that the directors used good risk management rules (as German banks did at the time). Yet, could they have seen the PSI before? Not a chance.

It is not just that there was no precedent in Europe. Those bonds were at their worst rated as A3, paid a significant amount of interest and were considered zero risk by everyone. Many (including yours truly) would like to see a post dated prior to 2009, stating that Greece, or any other country in the EU for that matter, would face so much trouble that a bond haircut would occur and that the risk premium was high. Yet, I have serious doubts on whether anyone was able to do it (and first of all, I admit that I could not see such a thing happen in a million years).

We should all be very careful in promoting policies which are based on "we could have seen this" arguments, since most of the times we wouldn't be in a bad situation if we could have really seen it coming. This is not providing an excuse for everything though: the Greek, Italian and Portuguese governments had been overspending for at least the past 10 years and Spain and Cyprus were in a housing bubble which was doomed to burst sooner or later. Nevertheless, the timing of such bursting, including its outcome are mostly unknown as I have argued before. Prevention should not be confused with vague forecasts of disasters. "This time it's different" has about the same validity as the "we could have seen this coming" premise and any policy based on our ability (or willingness) to see the future is doomed to fail.

When do Bubbles Burst? Or how do we know that we have hit the ceiling?

There has been a wide talk about the determinants of the financial crisis as well as our ability to forecast it. Many neoclassical economists argue that we could not have predicted anything; yet some of their colleagues did (with varying degrees of success). Keynesians, (or more likely Minskyans) such as Steve Keen are said to have predicted the credit crunch and the crash that followed. Austrian economists have also had their share of predicting as well, again with various degrees of success.

This paper by Dirk Bezemer, presents a list of people who have "anticipated" the financial crisis, as early as 2005 (page 9 of the said paper). Notable names include Robert Shiller (2006), Nouriel Roubini (2005 and 2006) and Steve Keen (2006). Some of the common reasons of analysts/economists behind their predictions are:

1. “a concern with financial assets as distinct from real-sector assets,
2. with the credit flows that finance both forms of wealth,
3. with the debt growth accompanying growth in financial wealth, and
4. with the accounting relation between the financial and real economy.”

Yet, the reasons behind their estimations do not seem so clear. For example have a look at the following graph, obtained by Keen's blog:

With no intention of being disrespectful to neither of the economists/analysts whose views were proven to be much better (to be exact here would be to use infinitely better) than their colleagues, I cannot help ask the following: why should it happen in 2008 and not earlier?

Have a look at reason 3. Debt growth accompanying growth in financial wealth. How can we know that a ceiling has been reached? We can know when we are exceeding the "normal" levels but why not in 2001 when the debt-to-GDP ration was higher than the one in the Great Depression of the 1930's? (the careful reader will see that at the initiation of the Great Depression the debt-to-GDP ratio was less than 175% of GDP, approximately the same as in 1995-1996)

The next graph indicates the level of home owners in the red line (i.e. the percentage of people who choose to buy a house instead of renting one) and the percentage of sub-prime loans compared to overall loans in the US economy.

Home ownership began its decrease in 2004; yet, sub-prime loans boomed during that period. One really has to wonder who the bankers were lending to. Less people willing to buy a house in addition to more sub-prime loans... This might just be the answer, yet why didn't the break happen earlier?

Prices in the US cannot point to the answer as they are not the ones causing the crunch, but the ones receiving it. The Case-Shiller index, however, may state otherwise:

Here, it appears that the index peaked in 2006, dropped lightly until 2007 and started a free-fall in 2007. Could we have known that 2006 was the peak year of the index, ex ante? I have no definite answer to that question. Surely, some people believed that then. And history proved them right. Yet, a prediction on its own is not enough. We have to understand the rationale behind these forecasts. Why wasn't the peak of the debt-to-GDP ratio in 2004 or 2005? Foreclosures were also increased after 2007. But not before it.

Correlations, co-movements or links are easy to find ex post. We know what happened, thus we can find what we are looking for. Yet, we are subject to what is called as Survivorship Bias. We concentrate on the people or things that "survived" some process and inadvertently overlooking those that didn't because of their lack of visibility. 

In other words, we can see more clearly looking back. Keen is right that most macroeconomic models do not account for the four factors mentioned above. Yet, even if they did could they have predicted when we would reach a ceiling? Not really. We are still unaware of many issues which help in lengthening a bubble's life. These are our known unknowns. Each case is somewhat unique in its determinants and evolution, not to mention length. We could have suspected that we were experiencing one when prices exploded for a large period of time. Nevertheless, we could not know when it would burst.

Could we have know whether we were experiencing a bubble as early as 2006? Probably yes. Could we have known when it would burst? Probably not.

To quote Keynes: "Markets can remain irrational much longer than you can remain solvent"

A change in mentality?

Over the last week a serious change in attitude towards ailing countries within the EU has occurred. Leading with Chancellor Angela Merkel, the political scene in Europe has witnessed a 180 degrees turn. The change was so radical and impressive that Der Spiegel has published a full article on this. This could mean one of three things: 

1. The South has made real progress over the last month (hmm or week maybe?).

2. Merkel has understood that her policies and stance are making both her as well as Germans in general extremely unpopular in Europe (and elections are coming up in a year).

3. She has accepted that trying to push through many things very rapidly is not such a great policy after all.

Whatever the reason may be (Spiegel states that it's No2) the fact is that leaders now appear to be more united than ever before. Even statements of the "Greece should leave the euro/Union" kind are treated coldly by EU officials now. Still, as progress for unification in the political level appears to be improved the economy still fails to recover. Italy, just like Spain and Greece, has seen unemployment rates soar over the last months. While Mario Monti is doing his best to improve the overall economy, unemployment of youths under 25 has reached 40%. And with recession here to stay in Italy (forecasts expect GDP to contract by 2% this year) the situation does not seem to improve. 

European leaders fail to understand that people cannot live on GDP. After an EU-wide summit on unemployment nothing seems to have changed: the employed have not (cannot?) find anything to do about the jobless. I have proposed my set of ideas over reducing unemployment here, and while the list I have presented is not exhausting nothing has been done yet. Just as I have predicted, the EU will face a recession over the next few months. New evidence indicate that the recession will be far worse than we expected. The Purchasing Managers' Index (PMI) for the Eurozone predicts that the output will shrink by 0.5-0.6% over the current quarter instead of the initial 0.2% prediction. 

The worst part of these forecasts is that the EU's safest economy, the one where people actually paid to invest their money, Germany, is bound to move to the red. The OECD predicts that although Germany has grown by 0.5% and 0.3% in the first two quarters, in the following two an annualized contraction of 0.5% and 0.8% is expected. Only France may be able to remain more-or-less unscathed with output falling this quarter and rising on the next.

In addition to all these, Mario Draghi has announced a program allowing unlimited purchases of sovereign bonds in the secondary market, in order to keep interest rates at sustainable levels. The only opposition to this program is Bundesbank head Jens Weidmann who believes that the program is too close to state financing through the money press. He may be right up to a point, however, I do believe that the program is much ado over nothing, The problem with what Draghi has proposed is that the ECB will only assist countries that appeal for help to the euro bailout fund and submit to the required austerity conditions. What he also meant is that the ECB would only be able to do this for nations which are not considered as junk by the 3 rating agencies (Moody's, Fitch, S&P), i.e. Greece and Cyprus cannot be assisted.

Thus this leaves only two countries: Italy and Spain. However, the announcement failed to mention the amount which would be available to fund this action. Given the size of the Italian and the Spanish economy, it would have to be enormous. Yet, we are still unaware of the size and extent of the intervention and it would be nice to know some more details about it instead of the general idea.

In the meanwhile, what journalists have not yet proposed is that another reason of Merkel's newly appeared empathy towards the crisis-ridden countries maybe be that she is preparing to identify herself with the rest of the ailing nations if OECD forecasts are true. We will just have to wait until the official data is published to find out.