Philadelphia Reflections

Cyprus Tests the Limits of Paper Money

Cyprus Map

Tourists like to banter about their favorite place in the whole world; until recently, mine was Cyprus. It's an eastern Mediterranean island, where it was possible to swim from beaches in the morning, ski in the afternoon, and luxuriate in an inexpensive but posh hotel in the evening. The locals had their ethnic rivalries, but what would tourist care. Since I was last there, apparently Russian and other billionaires discovered the place, and now three local banks are bigger than the GNP of the nation. Like Ireland, Hungary, Iceland, and several other small European nations, this dystrophic growth made it impossible for the government to guarantee the assets of the banks, as the familiar "lender of last resort" because the banks were bigger than the government. Accordingly, the local government was forced to declare a protracted bank holiday, to forestall what was certainly going to turn into a run on the banks as depositors all tried to get out the door at the same time. International stock markets immediately dropped a noticeable number of points, as the whole world suddenly discovered Cyprus wasn't such a nice place to put your money after all. The Russians might possibly be nasty people, but in this matter of bank deposits, people all link arms internationally like brothers.

There have been lots of other bank panics in small nations without much agitation, so what seems to have bothered the markets was the decision of the Central European Bank to tax the depositors 10% to support the system. Christine Lagarde, the head of the International Monetary Fund, said she thought it was a good idea to tax depositors, and that really upset a lot more people. Ms. Lagarde is French, but the IMF which she heads is located a few blocks from the U.S. White House, so the suspicion grew that Mr. Obama might approve of placing a tax on bank deposits, too. As things started to get out of hand, everyone hastily dropped the whole idea, and even the Cypriote Parliament voted against it. There was no time for even the large organizations devoted to managing the news to manage this one. World opinion was instantaneously mobilized, and thunderous in voicing its low opinion of taxing bank deposits, by anyone, anywhere. What was accidentally aroused was the realization that since the World went off the gold standard in 1971, the world's money is backed by nothing at all except a computer notation? Irrevocably taxing it in bank accounts could be done in an hour.

In 1944 the international conference held at Bretton Woods, New Hampshire, agreed that other nations could exchange their currency for American dollars, but only the U.S. dollar could be converted into gold. As long as the U.S. ran a trade surplus, the gold remained undisturbed in Fort Knox. But when other nations began to export their goods in the 1960s, their dollars began to be changed into gold. Gresham's Law took over quickly since when two currencies of unequal value circulate together, the more valuable one will quickly disappear; the shifting balance of trade had made gold more valuable than dollar bills. When President Nixon began to see that Fort Knox was soon going to be emptied, he put a stop to the exchange. He "closed the gold window". At that point, we were all off the gold standard, but nothing much happened. It remained possible to continue to speak of gold as a "barbarous relic", and by implication, any standard like silver or oil or land was also a barbarous relic. But the experience of Cyprus taught the world that everyone did want the value of a currency to be independent of the whims of government, and like the Emperor's suit of clothes, was just waiting for someone to point it out. A system of monetary exchanges, or exchanges of goods and services, really can be run without backing by anything except the word of government. But inflation targeting does need a government to run it, and thus governments have acquired a power over currencies which centuries of experience had taught people not to trust for a moment. North and South American hemispheric trade had been comfortably run without governments for centuries, as long as there were Spanish pieces of eight in actual circulation. But the modern Cyprus government could not run for a week without the trust of depositors, and neither can any other government. Conversely, it is impossible to run an economy without a government to guarantee the international value of money. People don't like that situation, and the threat of chaos in the streets is not much different in any place in the world which does not run a brutal military system. When you reach a point where even the soldiers refuse to be paid with paper money, you are about at the point General George Washington found himself after the Revolution. Robert Morris convinced him it would be possible to base a currency on the credit of the nation, and General Alexander Hamilton had been taught how to run such a thing. The rest of the country didn't understand what that meant, but they did understand that it seemed to work. But it would only work if the people trusted their Constitution, and the government is designed. But then, our government never tried to put a tax on bank deposits. In fact, it took another hundred years before the American public was completely certain you could trust banks even to exist. The good ol' mattress, that's where to keep your money. If it's in gold coins, that is. Paper money might just as well be in a bank because its value is only symbolic of a government promise.

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REFERENCES

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The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order: Benn Steil: ISBN-13: 978-0691149097	Amazon
Robert Morris: Financier of the American Revolution: Charles Rappleye: ISBN-10: 1416570926	Amazon
Bitter Lemons: Lawrence Durrell: ISBN-13: 978-1604190045	Amazon

Originally published: Wednesday, March 20, 2013; most-recently modified: Sunday, July 21, 2019