Windfall Tax on Lithuanian Banks Will Damage the Whole Ecosystem

Marinus van Reymerswaele: The moneychanger and his wife // Public domain

The narrative of excess profits that recently sparked in public discussions in Lithuania was not accidental. Initially, business companies had been suspected of profiting from inflation. Then suspicions of undeserved profits hit banks. And here we are – digesting a proposal from the government to impose  a special windfall tax on banks.

Obviously, the tax will affect banks, curb competition, and further damage Lithuania’s shallow financial. But let us look closer at how it will affect us all and the ecosystem itself.

The Bank of Lithuania concluded that banks earned abnormal profits because of their ‘excess liquidity’. What does this fancy term really mean? Simply put, it means excess money. Where does it come from? Since the start of the pandemic, the money supply has grown by a quarter in the euro area and by one-third in Lithuania. The monetary and fiscal stimuli that were activated during the pandemic created a surplus of money which we ultimately observed in the form of deposits.

After all, every subsidy doled out by the EU and every credit in the banking system lands up in the current account, i.e. it raises the deposit side. It can then be used as a source for new credits which ultimately end up as deposits again. That’s how surplus evolves. That is why the ecosystem provides no incentive to increase the interest on deposits.

Commercial banks keep the money they do not lend out at the European Central Bank (ECB). This is their business model. When the ECB started to raise interest rates, the interest rates on the banks’ reserves held at the ECB increases too. Is this a golden age for banks? They just lived through a decade of zero interest rates and are now living in anticipation of an economic crisis and recession.

A freezing economy means more borrowers who will be unable to repay their loans. The recent collapse of the US banks is sending an alarm. ‘Excess liquidity’ can evaporate in an hour. Therefore, what needs to be taken care of is the stability and trust in the banking system, rather than shearing the wool and inadvertently bleeding the banks. It is against logic to compare the results of the abnormal decade of zero interest rates with today‘s situation, and, on top of that, to disregard the growth that occurred over the past four years and the inflation that fuelled everything up.

The accumulation of excess money in the blood vessels of the economy sends an SOS signal to the architects of monetary policy. The fact that they seem unable to address the problem fundamentally by changing the direction of the monetary policy sends another SOS. This means that the circulation of money will be further disrupted and this will keep distorting the fundamental proportions of the ecosystem.

Ultimately, this will lead to more redistribution, and redistribution always has its winners and losers, or – if we use modern lexicon – those who receive “undeserved” gains and … losses. Among the winners, economic theory names borrowers and the treasury. Will the government tax some and compensate others on a quarterly basis?

The new windfall tax is to be levied not even on profits but on “net interest income.” It means that banks will be forced to mitigate risks and pursue the ultimate “normal profit” with minimum risk. This will hardly lead to higher deposit rates, as the government‘s thinking goes. Rather, we are going to see a drop in the credit volumes and an increase in the reserves that banks safely store at the ECB. The reckless fiscal interventions in our banking system threaten its transformations that might ultimately harm the whole ecosystem.

The windfall tax on banks does not bode any good in terms of competition either. Who will venture to enter and invest in a small market that places additional taxes on banks? The ECB has already criticized Spain‘s windfall tax on banks‘ profits saying that it would disrupt the monetary policy and affect the pricing of financial services.

Meanwhile, we in Lithuania are adding another risk on top of the looming geopolitical threats. And this particular risk will not only affect banks. At some point, it will create spill-over effects into another sector of “undeserved profits.”

The Lithuanian government argues that the windfall tax on banks will serve to finance military infrastructure. This is a serious argument indeed. In fact, it is too serious to allow ourselves the luxury of linking it to a windfall tax on banks without really knowing when it might be enacted or how much revenue it will actually bring.

If it is really imperative for Lithuania to invest in military infrastructure for security reasons, we should act quickly and responsibly: revise our budget allocations or issue bonds that all citizens could access. Entrusting the country‘s defence to the amount of a windfall tax that the banks might or might not pay would be an inexcusable delay.

Continue exploring:

What Does Word Inflation Really Mean?

High Inflation in Poland Is Caused by Monetary Policy Council

Elena Leontjeva