Edward Hadas

For once, investors have got it right. In 2008, their panic turned a financial crisis into a long multinational recession, but they have mostly yawned right through the drama in Nicosia. They hardly twitched at a stream of warnings from investment banks and pundits: bank deposits are no longer sacrosanct; the European Union has been exposed as despotic and incompetent; the Russians are coming; the Russians are going; capital controls will destroy everything; “bail in” (taking losses on loans that cannot be repaid) is the end of the world as we once knew it.

Such talk was out of proportion. Cyprus is a small country – its GDP would put it at 116 on the Fortune 500 list of the largest quoted U.S. companies – with a financial sector that had expanded excessively for two decades, almost entirely by attracting flight capital from Russia. A national financial collapse was both insignificant and merited. Besides, the EU and the International Monetary Fund had a plan to deal with the collapse: a combination of financial help from other countries and managed pain for depositors in Cypriot banks.

Alarmists could not deny all this, but they invoked the great demons of financial crises: precedent and contagion. That was silly. Cyprus was obviously a special case, and the European Central Bank was clearly determined, and able, to keep its problems from spreading. Even if Cyprus had left the euro zone, there would have been no dangerous precedents or grim effects, just a demonstration of a bizarre desire for economic self-harm. For everyone else, Cyprus would still be like a flea-bite – scratch for a minute and forget about it.

Why then have so many distinguished economists made so many dire predictions? I believe the answer is that they overestimate the current power of finance.

Recent history is on their side. For more than three decades, financiers almost always prevailed over political authorities. In the 1980s, they bamboozled politicians with spurious arguments for financial deregulation. In the 1990s, banks trampled over their regulators. In the early 2000s, central bankers became votaries at the altar of finance. They treated rising asset prices as signs of divine favour.

The headline could have come from a hundred places any time in the last hundred years. “Market has gone wild”, it read. The accompanying news report explains that the price of a crucial financial asset is in “free fall”. Traders and businessmen are calling on the government to step in.

The asset in question could be peripheral euro zone government debt today, global equity markets in early 2009. The wild market could have been soaring rather than falling: the stocks of 1929 and 1999, the house prices in Florida or London in the 2000s, or the supposedly safe government bonds today.

The actual headline comes from a Hong Kong newspaper in 1983, when investors in the then British colony began to fear the worst from a Chinese takeover. The UK’s Minister of State told the locals to “have confidence in yourselves”, but, as today’s Spanish and Italian politicians can ruefully confirm, such rhetoric is not enough to stop an investor stampede. A few weeks later, the Hong Kong authorities did indeed take the matter out of traders’ hands – they fixed the exchange rate between Hong Kong and U.S. dollars.

Once upon a time there were 11 prosperous merchants who lived in a land of peace and plenty. They decided to form a league that would work together for everyone’s greater good. But then a charming man in a fine suit came around with a tempting speech: “I love your project and trust your businesses. I will lend you money at a very attractive interest rate”. How nice, thought the merchants. Our customers will love us if we use the money we borrow to give them better deals.

All went so well that six other merchants were proud to join the league. Mr. Fine Suit seemed pleased. He reduced the already low interest rate on the loans. The merchants all planned to repay, but today was never quite right. Today, in fact, was always a good day to borrow more, while tomorrow always looked like a better day to raise prices.

Then one day Mr. Fine Suit changed his tune. “You know, you have a mighty nice little enterprise going here. But business is business, my friends. Interest rates are going to rise for some of you.” The merchants were angry, but what could they do? They promised to be more frugal, but still had to pay up. As the months went by, Mr. Fine Suit became more hostile. Just last week he came to the G-store, the most prosperous and prudent of all the merchants, with a really nasty threat. “You know, between us, I’ve never liked your stupid league. You’re much smarter than the rest. Leave the league and I’ll keep on lending you money at a low rate. If not, well, here’s a little reminder of what I can do.” He increased the interest rate by two notches before leaving the room with a menacing smirk.