We've known for awhile that the Cyprus bailout would be different to those that came before, but did anyone expect it to be this different? Let's set aside the past week's events for a moment and consider the bumbling March 16th decision to attempt a haircut on insured depositors. Although it was soon rejected by the Cypriot parliament, the inclusion of insured depositors in the initial agreement punctured the relative calm in Europe and seemed to catch everyone by surprise. I've yet to find an earlier analysis that flagged it as a realistic possibility. Which begs the question: Could it have been predicted? I'll argue here that the answer is "yes."
I'll start with the most obvious and proven rule of European politics: Ignore the public pronouncements of both officials from the EU and politicians from the broken economies in the periphery. You needed to follow this rule to have any hope of seeing things clearly.
The best example of the EU's knack for spreading confusion may have been a January interview with economics commissioner Olli Rehn, in which he called for a "very substantial restructuring" of both sovereign and bank debt. People may have paid more attention to that statement if he hadn't insisted that there was no need for such a restructuring just two weeks earlier.
And outgoing Eurogroup President Jean-Claude Juncker stayed true to his reputation, well-earned through his famous assertion that "when it becomes serious, you have to lie." In December, he suggested that "a haircut won't be among the measures used" in the bailout.
As for the Cypriot politicians, they repeatedly dismissed the idea that bank depositors could incur losses, right up until early March.
Not surprisingly, the best way to follow Europe's secret discussions wasn't through official statements but through leaks and anonymous sources. The Financial Times led the way, gaining access to confidential documents on two occasions. On December 3rd., it published a Memorandum of Understanding between the "troika" and Cyprus, which included language requiring the conversion of junior bank debt to equity. Then on February 10th., it reported details of a secret memo circulating among EU officials that identified haircuts on uninsured depositors as one of three options for mitigating the costs of a bailout.
And there were many other media reports that Europe was considering whether depositors should take losses. The New York Times mentioned depositor losses in an article that was published on January 10th. and relied on nameless "European officials." Later in January, the German weekly Spiegel also referenced the potential for depositor losses without attributing its sources.
But none of these insider accounts mentioned haircuts on insured depositors. The Speigel article stated that "experts" were "not considering accounts held by small savers," while other articles referred to haircuts on uninsured depositors only.
Clearly, we needed better information to predict the terms of the March 16th agreement, and I'll propose another rule in just a moment. Let's first consider how an accurate prediction might have looked. Imagine you had perused the Internet on, say, February 25th, and come across the following report:
Europe Poised to Shock Everyone and Rattle Global Markets
Cyprus elected a new president yesterday and paved the way for a resumption of bailout talks with the EU, ECB and IMF. Expect a surprising result.
We already know that the "troika" is demanding shared sacrifice in return for its continued support. If Cypriot stakeholders don't suffer losses, Cyprus's sovereign debt will almost certainly rise higher than the IMF and northern European nations can accept. But there are also less tangible factors to consider.
First, Angela Merkel desperately needs Cyprus's pain to be severe enough that it makes a strong political statement. German opposition to a bailout has grown since early November, when the influential weekly Spiegel gained access to a secret intelligence report and concluded that the bailout's beneficiaries would be "Russian oligarchs, businessmen and Mafiosi who have invested their illegal money in Cyprus." By January, senior officials in the ruling CDU/CSU coalition were joining the opposition Social Democrats in rejecting any bailout agreement that preserves Russian bank deposits.
This leaves Merkel between a rock and a hard place. Bank depositors will need to bleed badly in any bailout deal or it won't be approved by the German parliament. And if the parliament says "no," that would damage her chances for reelection while killing the bailout. In fact, regardless of the outcomes of the bailout negotiations and parliamentary vote, the public could still vote Merkel out of office in September's elections if she's too kind to Cyprus. She needs to show her constituents that she drove a brutal bargain.
Second, newly elected president Nicos Anastasiades needs to do absolutely everything in his power to protect large Cypriot depositors. These depositors propped up Cyprus's economy in recent years and without that prop the economy would suffer badly. But that's not all. Put yourself in Anastasiades's shoes and look at what he loses if large depositors are penalized too heavily:
Internationally, he loses his best and practically only friend. Russia is the sole counter-balance to the restrictive and unpopular dictates of Cyprus's overlords in Europe. The Russians awarded Cyprus a crucial 2.5 billion Euro loan last year and they did it without the indignity of a 30 page "Memorandum of Understanding." (The memorandum imposed on Cyprus by the troika mandates everything from the travel arrangements of government officials - coach class with few exceptions - to the opening hours of government offices - 8 a.m. sharp.) And this year, Anastasiades is counting on help from Russia once again.
Domestically, let's not forget that Anastasiades just won a major election and you don't just do that by yourself. You need many helpers, including quite a few from the ranks of the nation's political and economic elite. Anastasiades surely has supporters with business relationships with wealthy people holding large deposits in Cyprus's banks. And he surely has supporters who themselves hold large deposits. All of these supporters expect to be treated well by the new president.
I'll conclude that there's only one solution that sits at the intersection of Merkel's and Anastasiades's personal incentives. This is a broadly-applied tax on both insured and uninsured bank deposits. A broadly-applied tax would limit the damage to large depositors, freeing Anastasiades to assure key supporters that he did the best he could for them. And Merkel would be able to show the German public that she demanded shocking and painful sacrifices. Unprecedented, you might say.
As you know, this solution sits partly outside the range of possibilities that are currently being discussed by media pundits. And it won't sit well with the large numbers of bank depositors who'll be affected.
So mark your calendars for mid-March with the following notations: political uproar, market volatility and an island nation with less than a million inhabitants virtually taking over the global news cycle.
To be perfectly honest, if I had read this fake report in February or anytime before March 16th, I probably would have dismissed it. It just seems as though you're playing with fire by trying to take money from insured depositors. It's not a sensible option in my opinion, and I would have deemed it unlikely despite the decision makers' individual incentives. In hindsight, I would have put too much weight on my own thinking and not enough weight on how the key players might be approaching their decision.
Charlie Munger, Warren Buffett's longtime sidekick and legendary investor in his own right, once described the challenges of recognizing incentives like this:
I think I've been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I've always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.
I'm a few years younger than Munger and surely not as far along in my appreciation of "incentive superpower." But I intend to race everyone else to the top five percent that he mentions.
Getting back to my promise of a rule that might have helped in predicting the EU's surprising March 16th. announcement, I'll propose one that seems consistent with Munger's beliefs. The rule is this: When considering uncertain decisions such as the terms of a bailout, throw out logic and common sense and align your predictions with the decision makers' incentives.
Who knows? Maybe next time you'll figure out the real forces behind the decision and be the only one who calls it right.