Background on the Eurozone Crisis

When the concept of a central currency was introduced to the European Union, EU leaders had an optimistic outlook and disregarded the potential risks. The initial results were positive. Investor confidence in the member nation economies increased as they started attaching the security associated with German bonds to all other bonds of the Eurozone nations. Germany’s low interest rates became associated with the bonds of other member nations. Smaller countries with weaker economies, such as Greece and Ireland, were able to borrow money freely. With their economies doing well, none of the countries suspected anything to go wrong. Smaller countries increased their debts through new government entitlement programs and unnecessary expenditures, which they could not feasibly pay back.

This cheap borrowing fueled a housing bubble, which burst in 2008. Countries with large sectors of their economies dependent on the real estate market, such as Spain and Ireland, saw their revenues plummet, and their governments incurred huge losses and debts. When Greece’s government shifted in 2009 and hidden debts surfaced, investor confidence dropped and the flow of money into Greece greatly decreased. This propagated the economic collapse of these countries, and the costs of saving their economies steadily rose.

What happened with Cyprus?

Initially, Cyprus had a healthy economy, where the government had a budget surplus, the banking system was functional, and investments were pouring into the country. Yet, when Demetris Christofias, a member of the Communist party, was elected president in 2008, there was a shift in policies. With a healthy economy to support them, the government started spending more money and promising new government programs for Cypriots. These risky expenditures led to a decrease in capital inflow and foreign investors became wary of the new government policies.

The EU meeting in October 2011 strategized to solve Greece’s debt problems by wiping out nearly 80% of their debt held by the public sector. Cypriot banks were holding a lot of Greek debt, and incurred losses of approximately 5 billion dollars. With these losses and their loss of the international capital markets, Cypriot banks found it nearly impossible to meet the 9% capital requirements that were enacted by EU leaders.

Cyprus leaders decided it was time to look outwards for aid. The International Monetary Fund imposed terms for Cyprus to receive a 1 billion Euro bail out. IMF managing director Christine Lagarde supports austerity measures while ensuring “the poorest Cypriots would be protected from the worst of the cuts.” As a result, Cyprus imposed a one-off 9.99% tax on deposits greater than 100,000 Euros. Other austerity measures such as public sector cuts and tax increases “are estimated to save around 5% of GDP.”

What this means for the Eurozone

Cyprus is a model for what happens when a government values reelection over market security. Because of their unwillingness to restructure their financial markets, Cyprus will now have to enact politically unfavorable austerity measures to save their economy and debts. The one-off deposit taxes are punishment imposed by the IMF and ECB onto Cyprus for its risky financial endeavors. Yet, most of the fees will not target the real perpetrators of the crisis. The Telegraph of April 29, 2013 notes, “Here, it’s not oligarchs but middle-class entrepreneurs who have been devastated by the crisis.” The wealthiest, such as the Russian oligarchs, have intricate monetary distribution and thus only kept a small portion of their money in Cyprus banks and were not as greatly affected.

The IMF also asks for Cyprus to cut their social welfare programs and increase their low corporate income tax, both measures which in the long run will allow for a budget surplus, but in the short run, hurt both their citizens and foreign investors. One investment banker asked, “Why should I leave my money in Cyprus?” With the debt being placed onto bank depositors, it’s most likely that less people would want to place their money into Cyprus banks, mainly because they are worried that another bailout and deposit tax will happen again.

While being a part of the Eurozone allows for benefits such as easier transaction flows and financial security for smaller countries, these advantages also lead to irresponsible lending practices as seen by the current crisis. Smaller countries believe that larger countries will bail them out as needed, which is true as demonstrated by Germany’s bail out package to Cyprus. Possessing this mentality of financial security is useful to a certain extent—making risky investments is the way an institution can invest in new innovations and make unexpected returns. Yet, there has to be a limit at some point. Having a centralized currency reduces the flexibility each individual country has in solving their fiscal crisis. Because individual governments can no longer alter the value of their currency, imposing wage reduction measures in order to save employment and devaluating currency to encourage exports were no longer possible. Governments have to turn to unfavorable austerity measures, while hoping for bailouts from the International Monetary Fund and EU. What the EU needs the most now is solidarity to weather the crisis and institutional memory to ensure that another Cyprus or Greece doesn’t happen again.

By definition, fear and  greed mark periods of irrationality. These evil twins of speculation signal a move away from investment and into a world in which rumors, gossip, and irrational behavior rule the landscape. In the current market, a whisper of a potentially undesirable German Parliament vote could send markets down 3%.

History and psychology indicate that this is simply a bear market strung along by fear, an irrational decline that, although troublesome, will eventually return to “normal” levels. But even though the current stretch of fear is prolonged, intense, and volatile, the sobering backdrop of global financial crises and an extended recession continue to loom over the market.

Then perhaps the fear isn’t fear at all, but a justified symptom of a changing financial system.

Domestic macroeconomic issues include lagging unemployment numbers, slow GDP growth and a tremendous decrease in investment. On top of that, the housing market has begun to decline once again, corporate profits have taken another beating, and banks again are rumored to be undercapitalized. “There are issues about the weakness of banks and uncertainty about how the government will respond to another banking crisis,” says Professor Zitzewitz, an economics professor at Dartmouth College.

Even bigger issues lie overseas – the prolonged Greek debt crisis, and concerns over the solvency of Italy, Spain, and Portugal, threaten to send the Eurozone into a financial crisis of epic proportions.

With all of these potentially disastrous domestic and international issues, Thomas Flexner, Global Head of Real Estate at Citibank, believes that the market is behaving somewhat rationally. “This is reasonable fear based on the uncertainty of the markets,” he says. “Irrational implies that the fear is misplaced or unfounded.”

If, indeed, the fear is rational, then the consequences are severe. It suggests that the incredible world economic growth over the past several decades has been inflated.

“In the past twenty years, global markets were magnified by credit creation – easy central bank policies and easy leveraging created credit that turned into purchasing power, propelling global GDP,” says Flexner.

The debt owed to the creditors has to be paid back, slowly and painfully. This paying down of debt could drastically limit the advance of the global economy for many years. If our fears come true, then we could be entering a new economic reality of shrinking credit and a diminished financial  system.

At the same time, some investors continue to make big bets on our financial system, confident that the American economy can come out of the recession unscathed and unchanged. Some might argue that the bear market has been exaggerated, that although some of the concerns are real, the sharp decline in the equities market has been intensified by fear and rumor-mongering.

On August 18th, 2011, the Dow declined a whopping 415 points based on a “trio of disappointing economic readings” and a Morgan Stanley report that the US and Europe may be heading for another recession.

Those losses were erased a few days later as the Dow posted consecutive gains of 322 and 145 points based on an “FDIC report that the number of US banks in trouble is declining.” The Dow slipped 388 points on September 22nd, 2011, for a 3.48% loss based on “several reports…warning of the dangers of another global recession.”

Again, the losses were erased by a 272 point rise two days later on rumors that the German Parliament would vote to expand the bailout fund for Greece.

From this, it seems that the extreme upswings and downswings in stock prices can be attributed to only a few economic reports. To a rational observer, a few poor (but far from disastrous) economic readings should not lead to a 3.48% decline in the blue-chip stock index of the most financially powerful nation in the world.

The tremendous attention that investors are paying to small,  insignificant data points may be evidence that the levels of fear currently exceed market rationality. “The market is moving around more than justified by the news,” Professor Zitzewitz says.

The fear could be stemming from group psychology. The closeness of the financial community, in which relationships rule all, could potentially lead to prolonged bouts of groupthink in which traders and investors move together in herd behavior, acquiring information only from those already within the circle and of the same mindset.

As a result, the effects of a single, unfounded rumor is intensified as it moves through the collective conscious of the financial markets, unchallenged by outside analysis.

Prospect theory also suggests that people who have already achieved gains would be risk-averse, while those who have suffered losses become risk-loving.

It’s possible that as investors received overwhelmingly favorable returns in 2009 and 2010 have now become risk-averse, and even the slightest tremor in the financial bedrock would lead them to quickly shift their investments to less risky instruments.

Ironically, it is the very fear that leads investors to take their money out of stocks that makes the stock market decline. The actions of the investors are a self-fulfilling prophecy.

The fear, volatility, and global decline in financial markets may not be justified, but by their very existence, create an environment that reaffirms their fear.

As Flexner states, “Fear, unfortunately, becomes self-fulfilling. It’s investor’s fear that creates redemptions, forces hedge funds to sell their liquid assets, and eventually decreases the values of those very assets. That’s the biggest problem with fear. Fear in the financial markets transmutes itself into  reality.”