Today the Cyprus parliament is expected to approve a special tax on bank deposits, which will confiscate 6.75 percent and up of all bank deposits in the country. The plan has created a run on the banks in Cyprus, forcing them all to close. If there is action today, the banks may be able to reopen tomorrow, so some sort of action is expected.
Or maybe not. After all, the emergency session of parliament was already postponed from yesterday to today, a strange move when the country’s financial future is on the line. But then, everything about the situation is strange. The stiff tax on bank deposits would be shocking if Cyprus had come up with the idea on its own. But instead, it is adopting the measure at the insistence of the EU. This is puzzling in more ways than one.
First, the tax on its face appears to violate the EU deposit insurance law. Perhaps that legal difficulty could be avoided by exempting the first 100,000 euros of deposits from the tax, or something similar. But regardless of the details, it is a sign of weakness in the EU that an official EU delegation is requiring a measure that other EU officials are decrying as illegal.
The thought of a tax that would confiscate about 1/15 of every bank account was enough to lead to a run on the banks in Cyprus, forcing the banks to close, though most were ready to close for the weekend anyway. But what of banks in other EU countries? If the EU requires a deposit tax in Cyprus this week, with no advance warning, how long before it pushes a similar measure onto Spain . . . Ireland . . . even Germany? And with banks paying essentially zero in interest on deposits, there is a strong incentive for ordinary depositors to withdraw much of their savings from the banks and keep it in currency. I am not expecting a run on the banks in Italy or Greece this week, but given the degree of concern about the story among consumers across Europe, a degree of deposit flight, perhaps in the neighborhood of 5 or 10 percent, seems almost inevitable. This loss of deposits might not seem like much, but banks are so highly leveraged that a 10 percent loss of deposits is enough to take a bank from the edge of stability to the edge of ruin. In normal times, a bank can adapt to deposit flight by selling its assets to other banks, but that is not an option when deposit flight hits all banks at once. The European Central Bank will be forced to devise a new mechanism to prop up the banking system, this time in its entirety.
Setting aside the question of the stability of the banking system, a loss of deposits on this scale is ordinarily expected to lead to a monetary contraction large enough to trigger a snap recession. In other words, everyone in Europe will suffer from this decision.
And for what? The measure was supposed to save the banks in Cyprus, but whether the tax goes ahead or not, those banks are about to lose between one fourth and one half of their deposits. If the tax does not go ahead, depositors have every reason to worry that the government could change its mind next week or next year and reinstate the tax, again without warning. Actually, that is a risk even if the tax does go through — perhaps, like so many austerity measures, it could be repeated. And if the tax does go ahead and depositors have 1/15 of their deposits confiscated, many will not fully trust the banks again for the rest of their lives. Many of the depositors in Cyprus are tourists or foreigners who can easily move their money to a better “safe haven.” The political theory is that people will not move their money because they will realize it is already too late. I have a hard time imagining that working in practice. Absent some dramatic development that I cannot imagine at this point, the banks in Cyprus will be ruined regardless of what happens next. If cooler heads prevail, parliament will let the banks stay closed while they work on a more rational way forward. That is the only hope of avoiding disaster in Cyprus at this point.
That will not solve the problem for the EU, though. With deposit flight soon to undermine the banks across Europe, the EU will be plunged into crisis. The strange thing about this whole sequence is that there was no external event that forced the EU into this kind of action. It was entirely self-inflicted, every bit as much as the October 2008 financial collapse that the Fed and White House engineered in the United States. The EU essentially just shot itself in the foot. It is an injury that may hurt for a long time to come, and with so many other things uncertain at this point, there has to be a degree of doubt about whether it will ever walk again.