What is wrong with the islands?

Paul Krugman writes:

Let me make a broader point: we’ve now seen three island nations around Europe become huge international banking hubs relative to their GDPs, then get into crisis because their domestic economies don’t have the resources to bail out those metastasized banking systems if something goes wrong. This strongly suggests, to me at least, that we have a fundamental problem with the whole architecture (to use the preferred fancy word) of international finance.

…All of which raises the question, is the era of free capital movement just a bubble, fated to end one of these years, maybe soon?

Of course there is more at the link.  The way I put this point is to suggest that the era of reliable deposit insurance may be coming to a close (and not for the better).  What kind of international capital regulations would or could limit this problem is a topic deserving of much more attention.  We can’t go back to Bretton Woods, numerous companies and developing economies already rely on international capital flows, and so what is actually on the table here?


The off-handed claim that developing countries "rely" on capital flows is at best incomplete. Brazil et al have been desperately looking for ways to *limit* hot capital inflows that are incompatible with their currency, inflation, and growth/interest rate regime. I think the support basin for hot international capital flows outside of high finance is much more limited than you suggest.

"I really shouldn't be doing any more of this" he said right before smoking another bowl...

The protestations are not credible if you keep hiking your interest rates, trying to depress your currency, and don't put in capital controls and then complain about "hot" money flowing in.

that's the point--we need capital controls, but Tyler's telling us we can't have them...

But Brazil doesn't really want them, or it would have them already.

Brazil has them already. 6% on any inflow into BRL. Pretty hefty. Google "IOF tax".

What makes Switzerland or Uruguay different from Iceland or Cyprus?

Or did I mean Paraguay? Whichever.

The former two are not islands, which was the critical distinction drawn in Krugman's "broader point".

Ah yes, since they're not islands, they can't capsize.

Are you making fun of me?

Oh you've gaummed onto me.

What makes Switzerland different?

Switzerland shoves the risk back to the bank and its shareholders and employees. When the Swiss investment banks were turning down, the Swiss demanded that the employees of investment banks be given the bad debt as their compensation. They also have clawback.

The Swiss are smarter than we are. The English, on the other hand, acquired stock in banks to add liquidity, let the investment bankers make money (although now trying to cap or tax it), and did not shove the bad debts back to the investment banker employees.

Who is smarter?

I'd say the Swiss, and, if the Cypriot deal goes through, the Cypriots.

The Swiss have been at this banking thing for a long time, they have a banking culture that developed when the personal probity of the banker was the chief assurance that the depositor had and deposit insurance was inconceivable. This has served them well.

So what about Uruguay?


Do you have a link for the Swiss experience?

Thanks in advance.

Dan, google "UBS and clawback" I remember and cannot find an article where the Swiss government pressured UBS as a condition for assistance to create a clawback program, and I believe there was also a program where executives were required to take a share of the bad debts as their compensation. Unfortunately, I cannot find the latter reference after going through 5 pages of links.

Credit Suisse did an amusing little trick of, I believe, allowing its employees to take illiquid and tricky credit muck as comp. Not a regulator-imposed structure, just a short lived experiment. I suppose it's less exciting when it's not imposed, sorry.

Why is it a pity for "reliable deposit insurance may be coming to a close (and not for the better)."? What proportion of people have deposits of 100,000 euros? That's a fortune to me (even though I'm on a high income); yes to protect a month's pay so you can change accounts when a bank fails, yes even to some savings protection (say a year's pay i.e. median year's pay) by state but why so much? Should those with piles of spare cash be expected to spread their cash around, why should taxpayers foot the bill?
We have protection on pensions (ultimately the state pension) people will be able to afford to live, even if it's a bit crap but I don't think reliance on income tax payers (predominately) is fair.

The short answer is that runs are the bank are insanely destructive, yet this will become much more common without deposit insurance in a system of fractional reserve banking.

I think you're right. Ultimately, in the long run, i think we'll come to realize that the past 80 years of financial stability through regulation has been an illusion. What these tightly regulated financial sectors yield is not to rid us of risk, but instead to shift from idiosyncratic risk into systemic risk. The problem with systemic risk, is that when it happens, it is much more devastating than if a single bank makes a bad bed. Our recent crash was triggered by our most tightly regulated financial sub-sector. When you force everybody to be the same, they all make the same mistakes.

Financial management 101 is diversification, diversification, diversification. When will we learn this lesson for financial regulation as well?

'i think we’ll come to realize that the past 80 years of financial stability through regulation has been an illusion'

Well, except for the fact that there was, roughly, 80 years of financial stability. And that when in a place like the U.S., those regulations that were enacted to ensure financial stability were gutted, we subsequently returned to many of the identical problems that existed before those regulations were put into place, providing an empirical framework to show the stability was not only real, it was created in major part by design.

For a while, we thought putting out all forest fires when they crop up was a good idea. And it provided wonderful forest stability...for a while.

Except there wasn't a giant forest fire that engulfed the world. We still ban massive keggers with fireworks in national parks last I checked.

You can't ban lightning

Jan, your illogic is...baffling.

Interfluidity had a post on this once. Micro-fragility leads to macro-resilience. Like allowing the forest fires to avoid the build up of wood that would create a ball of flame. Same principle for banks and their investments, as opposed to saving them and ending up making more things too big to fail.


There was only half a century of bank stability in the US, from 1935 to 1985, and since then it has been bailout after bailout.

But in the 70s the move was on to deregulate with the promise of higher returns to depositors and lower fees to customers. After all, the Federal caps of 4-5% interest on deposits was outrageous, and being forced to pay 10 cents per checks would be a thing of the past with better technology and a free market of bank competition driving down fees.

The bailouts of the banks after the real estate crash at the end of the 80s cost billions in the 1990 TARP, and then billions more in 2008. But there were multiple other Federal interventions to save the US banking system from itself. Every crisis was caused by banks doing thing they could not have done from 1935 to 1975.

I am constantly astounded by the denial of the bank failures and Federal bailout in 1990 to be followed by shock that 2008 could have happened. Obviously part of the myth creation of Reagan and his economic genius - deny the major finance problems that resulted from his administration policies.

And the reason for deregulation was so the banks could diversify and become safer that they were for half a century when restricted to just banking. By diversifying, the banks mix insured depository banking with high risk operations some intertwined that to safe the depositors requires saving the parts that caused the deposits to be at risk.

A number of islands with outsize banking sectors, and a long history of bank stability, immediately pop to mind. Bermuda, Bahamas, Turks & Caicos, Caymans, etc.

Note that these are all former outposts of the British Empire, and that the banks operating there are largely foreign. Also, they all issue their own currencies, have capital controls in place, and segregate the foreign from domestic banking sectors.

Yes, it's all terribly old school, and it produces banking jobs at the expense of the broader local economy... but it has kept them out of trouble.

A number of islands with outsize banking sectors, and a long history of bank stability, immediately pop to mind. Britain.

Turks & Caicos Islands uses the dollar, not their own currency.

Bermuda is not a former British colony, it is a current British overseas territory.

No one likes a pedant.

I this causes bank runs in other EU states, then that will be unfortunate. But really deposit insurance on accounts over 100K in Cyprus? Doesn't this really just solve your island banking center problem? If you want a tax haven, go off-shore. If you want reliable banking, keep it a big, safe, western state, preferably the one you do business in. As long as people understand the deal, this shouldn't be an issue.

If you want reliable banking, keep it a big, safe, western state, preferably the one you do business in.

If you were and Italian who owned his own company, would you keep your money in an Italian bank? If the answer is no, then Italy's banking system looks perilous...and with it the rest of the country.

'If you were and Italian who owned his own company, would you keep your money in an Italian bank? If the answer is no, then Italy’s banking system looks perilous…and with it the rest of the country.'

So, the multiple decades old Italian preference for secret Swiss bank accounts (or cash - why get banks involved at all) is a sign of how perilous Italy looks?

The more things stay the same ....

Some of the longstanding fondness of Italians for foreign accounts comes from their reluctance to pay taxes. An off feature of Italy is that few wealthy Italians own anything (on paper). Their stuff is always owned by some corporation, usually in in another country, and they have very low incomes.

"This strongly suggests, to me at least, that we have a fundamental problem with the whole architecture (to use the preferred fancy word) of international finance."
- Yes.

"…All of which raises the question, is the era of free capital movement just a bubble, fated to end one of these years, maybe soon?"
- Nonsense. Although fascists like Krugman will push in this direction, the age of bitcoin is upon us. (I don't use the term Fascist lightly, but Krugman shares a great many similarities with the totalitarian nationalist socialists in his economic ideology.)

The problem is taxation and to a less extent criminal/anti-money-laundering laws.

Remove those and there's no longer any need to do banking in "islands".

Suppose I accept your pre-condition: The era or reliable deposit insurance is over. (Note: I can't believe we're even having this discussion).

Ok - well how do we keep banks solvent? If governments can't provide reliable insurance (and increasingly, they can't) we have to look to private alternatives. We should be encouraging banks to offer option accounts convertible into equity and or interest bearing notes. Arguably, this is what Germany should be encouraging Spain and Italy to do now. This would substantially reduce the likelihood/efficacy of bank runs.

Suddenly, you start thinking about the implications of this and you realize we're walking backward towards free-banking. It's madness. But the alternatives are pretty terrible. The 1800's had a lot of banking panics. If technology increases the pace of information, it also increases the pace of bank runs. Scottish free-banking starts to look like an attractive option.

I don't know what this says about the world. It's scary. Maybe Cyprus should hire George Selgin as a consultant.

Attempting to create a nuclear-backed utopia in an effort to eliminate risk is pretty scary too. The ante just keeps going up: increase scale, increase global governance, trust in faceless bureaucrats. No thanks.

You mean like the Cypress case of giving the depositors equity in the banks in exchange for the 6-10% haircut?

I really don't mean Cyprus. I think it's too late. I mean Italy, Spain, Portugal... maybe everywhere.

Essentially, you can re-create the Cyprus bail-out, but do it in a way that is voluntary and converts only the accounts of those willing to bear the risk. As a side benefit, the rate of return/equity on these convertible accounts would function as a much better arbiter of banking soundness.

As I recall, the original Glass-Steagall bill included super subordinate, floating rate loans that would fluctuate. This was stripped out for reasons (I suspect) related to large banking influence in the legislature. But the purpose was to force banks to compete along the dimension of risk. We should be doing this now.

I think that deposits are overrated, at least in parts of the world where savings are low and financial "innovation" is high. They mean a lot to their owners, but not to their banks, or their debtors. It's more like "you're not a proper bank if you don't allow deposits". That's why they're liabilities in the minds of bankers, and the credits they've given are assets :P

A deposit is just one of the means by which you achieve your capital reserve quota, allowing you to lend more from thin air. With all the ridiculous leveraging going on, and credit default swaps etc, the role of deposits to the actual game of finance has steadily declined. They are still important, however, to their owners, since it's their reserve.

That's why i propose that you create two kinds of banks: one with 100% capital requirement, the other with 0. The first should have as clients people who are content to just keeping up with inflation on their deposist by buying same currency government bonds and people who don't really want you to play coy with their money and just want an account to make payments from (it would be even better if they gave up the fiction that online transactions, or setting up new accounts and transfers and the like, actually cost anything in the era of cheap internet infrastructure and stop charging arms and legs, like https://simple.com/).

The second should be for cowboys who like to take risks with their money, and bond buyers and equity investors and central banks. They would be the ones who water the economy.

And let the dice fall where they may.

Only a NYT writer would call architecture a "fancy word."

And only Former Enron Advisor Paul Krugman finds it necessary to put the word "me" in every other sentence.

Two-for-two in the first quoted paragraph, no less.

Surely part of this is that small countries have more varied outcomes than larger ones (and island countries are more likely to be small) rather than being bad on average. Looking at finance centers specifically, how do Singapore, Luxembourg, Monaco, and the various Caribbean islands look? What about the Channel Islands, does that count as an island banking hub around Europe? For that matter, Bloomberg is reporting a 24% return on Cyprus bank deposits pre-bailin over the last five years (http://www.bloomberg.com/news/2013-03-18/cyprus-bank-deposits-returned-almost-twice-germany-s-since-2008.html) which even after a levy tops my CDs.

However, I would not be surprised if we have passed at least a local peak in capital flows: trust becomes more important relative to expected returns, home country bias gets stronger.

It seems to me that the problem is that the availability of deposit insurance is not synchronous with a coherent currency area. Either extend deposit insurance across a currency area, or shrink the currency area to match the scope of insurance. It's not the capital flows themselves that are the problem, but a promise by a government to make bank deposits good when it doesn't control its currency.

This is the euro problem in a nutshell. It needs to harmonize fiscal policy and regulation at the level of the currency. If that's not politically possible, the currency area is too big and needs to shrink to match the area that can politically support full fiscal, monetary, and regulatory union.

Iceland controlled its currency but "taxed" non-Icelanders 100% on their deposits in Icelandic banks - Icelanders got 100% insurance coverage on their deposits and every other depositor got nothing.

Iceland was/is required by its EU trade agreement to meet the EU requirement for deposit insurance, so the only way to explain non-Icelanders losing all their money in Icelandic banks is by a 100% tax on their deposits.

Seriously, the problem is a failure to regulate the banks. When banks do not have sufficient capital and do not require borrowers to have sufficient capital and revenue to service the debt, deposit insurance funds will fail.

Iceland failed to regulate just as Cypress failed, and Iceland was no better off than Cypress, other that being smaller.

The issue is directly related to fractional reserve banking and the instabilities the practice creates for domestic and international economies.

I support the Chicago Plan Revisited approach taken by Jaromir Benes and Michael Kumhof of the IMF.

The plan would do away with fractional reserve lending. Instead, the money supply would be entirely created through federal tax and spend policies.

When you want inflation, spend more than you tax. When you want deflation, tax more than you spend.

The authors suggest a panel of experts- like the Federal Reserve- determine the overall tax and spend levels. Politicians than determine how those levels are met.

If capitalistic nations and zones throughout the world adopted this approach, free flows of capital could still happen at a dramatically lower risk of banking defaults and panics.

Of course Market Monetarists love this proposal- its straight out of their playbook. I like it as well, as ever-increasing ratios of fractional reserve lending was THE major contributor to the last financial crisis. This website is full of people well-educated in finance and economics. I ask Marginal Revolution readers: In the entire history of banking, has their ever been a bank run caused by something other than fractional reserve lending?

So I think its a good way forward. But not perfect, as I perceive 5 downsides: 1) Tax and spending levels directed by unelected officials. 2) Pressure from banks to downplay inflation risks to increase the money supply and assets (This already happens, but directly linking lending to inflation will make such calls louder and more frequent). 3) More bankers entering the private, relatively unregulated field of shadow financing unrestrained by reserve requirements. 4) Having a national debt for infinity, because debt is the only way to increase the money supply and increasing the money supply is essential for the growth. 5) A further erosion of Congress to set monetary policy and for the Treasury to print such money accordingly, as directed by the Constitution.

Since I'm raising the reality of ending fractional reserve lending, I'll throw caution into the wind and discuss other steps that might be considered radical by people conditioned by present-day approaches. Ideally, I would end fractional reserve lending, to government debt with interest, and an end to the technocratic rule of the printing press. I don't consider the banking instabilities, unending national debts, and privatization of the printing press to be among the stories of progress in the past 200 years. I want people, institutions, and governments to replace debt with savings, for more stability of the financial and therefore economic system, and the inequality of the present system to become more equitable. The government printing debt-free money in a financial system of full reserve bank lending is a great place to start.

For the concern about out-of-control inflation under such a system, consider that Ben Franklin's colonial Pennsylvania had a monetary system wherein the government controlled the printing press, issued debt-free money to itself, and tightly restrained bank lending. The colony experienced decades of price stability and widely shared economic prosperity. Although certainly no utopia- loans were only granted to land owners and being a white Puritan certainly helped one's advancement- it did present a means to conduct a monetary policy that had stability in prices, banking, and created a society with a strong middle class. It was such a success that, upon learning about its success and details after Franklin became loose-lipped (Surely Ben wasn't drinking, lol), the British crown in London sought to shut it down in a series of laws designed to do away with colonial printing presses and make the colonies dependent upon British monetary policy, which was primarily concerned with the promoting interests of a few in The City of London while mostly indifferent to the masses of Londoners getting by paycheck-to-paycheck.

Indeed, the issue over who- the government or a private bank- prints the nation's currency played a major role in the Revolutionary War and was a continual presence in American politics- from the Constitution to Thomas Jefferson to Andrew Jackson to Abraham Lincoln- until it faded from public discorse the early 20th century, with the creation of the Federal Reserve signed by Woodrow Wilson. The fact that we have such a fragile, debt-ridden, and unequal economic system should come as no surprise to anyone aware of the consequences of having a combination fractional reserve lending and private control of the printing press.

If only banks actually were constrained by fractional banking these days...

Fractional banks presumes that require assets exceed the value of deposits, taking the sum total of bank capital plus the capital assets used as collateral for debt, plus the equity value of the income streams servicing the debt.

In the past quarter century, the bank capital requirements have been reduced, banks no longer verify the borrower equity, nor do they require an income stream to service the debt - the capital backing the deposits are a fraction of the deposits, instead of the other way around like it was from 1935-1985 in the US.


I agree that banks became out-of-control with fractional lending, naturally so since I argue for full-reserve lending. In 2007, the lending ratios for major American banks was 37:1, meaning that banks were lending $37 for every $1 in deposits. Since 2007, the ratios to conduct fractional reserve lending has been clipped by market expectations and regulations on lending practices and capital requirements.

You rightly noticed the increasingly risky lending practices of the past quarter century as the memories of the 1930s faded and supposedly risk-mitigating financial innovations like credit default swaps were introduced.

Despite the invention and proliferation of creative banking practices, these new tools could not prevent the 2007 Financial Crisis, which was an old-fashioned bank and financial panic. An injection of government capital into the banking system itself and a series of aggressive moves by the Federal Reserve stopped the panic from becoming a collapse and prevented the recession and sluggish recovery from being a deep worldwide depression with unpredictable political and societal outcomes.

Bank panics are the result of banks lending more than they have in deposits. Despite the clear record to the contrary, banks always delude themselves into believing "this time is different" as the lending ratios soar in sunny financial and economic times. When the economic weather changes from sunshine to threatening clouds, banks are unprepared as they hubristically presumed the good times of booming growth would never end. Then the banks need a quick injection of capital to increase their deposits or face insolvency. In 2007, some clever people at major American banks successfully argued that their banks were "too big to fail" and received the government's capital on friendly lending terms. Economists call such behavior anti-competitive and -capitalistic rent-seeking, and they are right.

Instead of injecting the banks with capital and passing new regulations on the banking industry, the government's priority should have been three-fold. First, ensure the short-term integrity of the financial system like it successfully did. Second, as soon as the sense of immediate panic and crisis fades, initiate an orderly process of unwinding the banks whose failure would have jeopardized the entire economy. Third, end the practice of fractional reserve lending and replace it with full-reserve lending. If there was criminal wrongdoing, prosecute under the assumption of innocence until proven guilty, but I favor forgiveness for past wrongs and mistakes above engaging in emotional witch-hunts.

Because of the recent crisis and subsequent reactions, the relationship between fractional lending, too-big-to-fail banks, and systematic risk is being quietly left behind as people focus on other important issues like reducing health care costs, improving education, responding to changing geopolitics, and trying to piece together the train wreck that is the Euro. As histories like the one you notice illustrate, banks will gradually chip away at these rules and engage in increasingly risky lending. Because of how policymakers responded in 2007, the profits made since, and the collective public shrug at such collusion, banks have incentives to make themselves even bigger, the lending even riskier, and the innovations even more exotic before the next panic.

I'm amending paragraph #9 where I state, "an end to the technocratic rule of the printing press."

Strike the word "technocratic" and replace it with "private." In my proposal, the United States Federal Government would become the sole shareholder and owner of the Federal Reserve.

Technocrats could still run it, especially considering the common correlation between political skill and economic illiteracy, at least from what politicians often assert in public.

There is another issue as well- what about government spending at the state and local level? If my hometown of Liberty, MO decided to spend more than it took in taxes, that act creates money for the Treasury to issue without interest. And if its debt is interest-free and there's no penalties for going into debt, wouldn't Liberty and all governments start running deficits with indifference and thereby cause out-of-control runaway inflation?

This is why economic technocrats should influence policy and politicians. The government could bind itself to an inflation target by setting legal limits on the deficits that states, counties, and cities can enter into. When conditions change- say a city gets whacked by a tornado or a state with an earthquake- the government could temporarily allow for greater deficits in those places to be offset by budget balances or surpluses elsewhere, or perhaps the Federal Government could lend money to these places on friendly terms through money printed interest-free at the Treasury. I'm speculating, through, and would appreciate any ideas or notions from the audience.

I support the Chicago Plan Revisited approach ... The authors suggest a panel of experts- like the Federal Reserve

Ha ha. Good one.

This is why economic technocrats should influence policy and politicians.

How many guns/votes do the economists have?

Iceland (not an EU member) also qualifies as a .
island nation around Europe.
After insanely deciding at first to bail out the foreigners(Norwegians, Britons, Russians) they came to their senses, fucked the foreigners, and devalued. Things are better now.

No, Iceland did not devalue. Iceland "taxed" foreign deposits at 100%. That way it did not need to pay off those insured deposits.

Iceland's currency value changed only because the profits from the banks had driven up Iceland's imports, but with the bank failures, Iceland had a trade imbalance.

Every article and blog post I've read about the Cyprus crisis assumes that the banking system there is facing bankruptcy and must be bailed out. I haven't read an explanation of this. If Russians and others are using Cyprus banks in their money-laundering operations, how does this bankrupt the banks? Are we sure it's not the government that has overspent and is thus seeking a bailout though the banks? Can someone explain?

Apparently the banks bought lots of Greek bonds that lost value.

I suspect that many of the foreign depositors in Cyprus regard their funds more like equity than debt, being denoted in a foreign currency which has probably fluctuated more than 10% against the ruble or whatever home currency you have. In addition they have almost certainly saved more in tax than this small levy will take. So I highly doubt this will reduce overall international trade flows. In fact this is exactly what you would want in a functioning system. Occasional hair cuts keep people aware of risks and make them more careful about who and where they put their money. Which means more work for investment recipients to develop credible systems to signal the ability to avoid this kind of issue, which in the longer term will increase flows.

Of course for the local depositors it is a bit more of an impact. But they must already be highly risk adverse people if they hadn't already moved their funds overseas. So I doubt there will be too much panic on the streets.

If you are going to impose ad hoc bank holidays, what is so wrong with a priori date certainty?

Who pays for this deposit insurance, and what are its actual effects?

What we apparently don't have is someone who gets rewarded handsomely enough to take the other side of the trade of the panicked deposit withdrawer.

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