Penny Wise, Euro Foolish

After spending more than four years and a half-trillion dollars trying to restore faith in their currency, their governments and their banks, the top financial minds in the eurozone may have thrown it all away over the weekend to save a pittance.

If you are cynical enough, you might say this is the kind of judgment we ought to expect by now from the top financial minds in the eurozone.

I am not that cynical – or at least I wasn’t, before the finance chiefs of 17 countries decided to raid every bank account in the island nation of Cyprus to raise part of a 17-billion-euro rescue package. As recently as Friday, the Cypriot government (which reluctantly agreed to the terms in order to stay in the euro club) proclaimed that bank deposits were sacrosanct. By Saturday, after word of the rescue deal’s terms got out, virtually every ATM in government-controlled Cyprus was empty of cash. (The exceptions were those machines in the portion of the country that Turkish forces have occupied since a 1974 invasion.)

Cypriot banks were supposed to reopen today after a three-day holiday weekend. They did not, on the government’s orders. It remains to be seen whether they will be open tomorrow. Whenever the doors finally open, there is a good chance we will see domestic and foreign customers of those banks rush to send their money elsewhere. Having been misled once, they have no reason to trust official assurances that this levy on their deposits is a one-time event. If Cyprus needs more funds beyond the current package, what would prevent a second raid on deposits?

You could call it the Willie Sutton theory of multilateral economics: When you don’t want to risk your own cash to bail out a neighbor, you go where somebody else’s money is.

In this case, “somebody else” is the Russian clientele that makes up a large part of the customer base of Cyprus’ banks. Quoting data from the Central Bank of Cyprus, Bloomberg reported yesterday that 31 percent of Cypriot bank deposits are from customers outside the euro area, mainly Russians, who tend to have large bank balances. These foreigners would have paid the bulk of the levy, which was initially set at 9.9 percent of deposits exceeding 100,000 euros. But even small accounts held by Cypriot citizens would have been hit with a seizure of 6.75 percent. This is effectively a tax on savings that would punish pensioners and small businesses.

On its own, Cyprus is not important to the world economy, or even to the eurozone, where it represents less than .005 of total economic output. The money required by the Nicosia government to bolster its banks and pay its bills – 17 billion euros – is pocket change next to the bailouts already approved for Ireland, Portugal, Greece and Spain. But taxpayers in Germany and other prosperous euro economies are tired of paying for what they see as the sins of their profligate partners. They resolved to extract their kilo of flesh.

But it seems the knife slipped. Financial markets tumbled around the world on Monday in reaction to the move. In Asia alone, stock markets lost an estimated $190 billion yesterday, with the situation in Cyprus a big factor (though new moves to tighten China’s real estate market were also in play). The euro dropped to its lowest level in months, while every major non-euro currency rose. Reversing recent trends, cash poured back into the perceived havens of American and German government bonds.

The problem is not just that that so-called “bail-in” of bank depositors is unfair. It is that the midnight raid set a precedent with nasty implications for bank customers all over the eurozone. Having seized deposits in Cyprus, why can’t the same eurozone finance ministers look to deposits in Spain, if its government requires further aid? Or Italy, or even France, should it appear that their sluggish economies and spending proclivities are going to get them into trouble? Not to mention Greece, whose multiple bailouts (which included a haircut for private holders of government bonds, while sparing the European Central Bank) still have not provided much assurance that it can return to solvency?

The move against tiny Cyprus may end up destabilizing the banking system in much of the eurozone and further retarding Europe’s economic recovery. It is almost impossible to revive an economy that lacks banks that are strong enough to lend. Without economic growth in the struggling euro countries, even the prosperous members like Germany, Finland, the Netherlands and Austria will suffer from shrunken export markets and repeated calls for financial aid, without which the struggling countries cannot afford to keep the euro.

From the German perspective, Cypriots ought to bear a big part of the cost of bailing out their own government and banks. This assumes Cypriots are mainly to blame for their own problems. But Cyprus did not foster an unsustainable building boom like Spain’s, or spend far beyond its means like Greece. Its problems stem mainly from the fact that government-controlled Cyprus is ethnically Greek and has close business, cultural and financial ties to Athens. Banks in Cyprus were major investors in Greek bonds, whose value plunged when that country ran off the financial rails. It now turns out that the ECB, having protected the value of its own Greek bond exposure, is imposing penalties on Cypriot savers and businesses as the price for offsetting some of the losses it imposed on their Greek holdings.

The big beneficiaries of the European moves, besides the debt-issuing treasuries in Washington and Berlin, are likely to be banks in non-euro nations like Switzerland, the United States, Canada and the United Kingdom. Those governments can point to an unblemished record of protecting depositors who – by law – are supposed to be protected, even if on rare occasions large account holders who exceed government insurance limits are exposed to some losses. Big depositors know the credit risks they take when they entrust large sums to banks, but they have no way to defend themselves against midnight government assaults aimed at bolstering the fisc.

The details of the Cyprus move were still in flux yesterday, amid proposals to reduce the tax on small accounts while increasing it on big ones. On the global stage, these details do not matter. What matters is that the eurozone has let it be known that bank accounts, no matter how modest the deposit nor how strong the institution, are up for grabs when a central government needs money. Nobody can look at a eurozone bank quite the same way since this weekend. Europe will pay a price for this, one that is liable to be far more than the pocket change it may squeeze out of Cypriot depositors.

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