\n\t\tThe Cyprus bailout package contains a tax on bank deposits. This column argues that the tax is a deeply dangerous policy that creates a new situation, more perilous than ever. It is a radical change that potentially undermines a perfectly reasonable deposit guarantee and the euro itself. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors in Spain and Italy.<\/em><\/p>\n

\n\t\tThe decision to tax all Cypriot bank deposits has attracted massive attention (Spiegel 2013) – and rightly so. It is a huge blunder:<\/p>\n

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\n\t\t\tIn the unlikely event that all goes well, the government will receive a bit of cash – but not enough to cover the loan generously offered by its European partners – and the Cypriot banking system will be history.<\/li>\n
\n\t\t\tThe alternative is a massive bank crisis in many Eurozone<\/span> countries – a huge blow to the euro, maybe even a fatal one.<\/li>\n<\/ul>\n
\n\t\tNot an emergency measure<\/strong><\/p>\n
\n\t\tPolicymakers have been debating the Cyprus bailout for nearly a year; this cannot be classified an 'emergency action'. They engaged in a lively debate whether Cyprus is 'systemic' or not, the answer to which can only be 'it depends'. It depends not on the size of Cypriot banks but on the way the Eurozone<\/span> acts. They also debated the Russian deposits that apparently represent a sizeable proportion of bank liabilities. The debate turned around the issues of how dirty this money is and how to do the laundry. They also debated on the size of a possible loan to the Cypriot government. The government itself requested something to the tune of 100% of its GDP, why not? After all this amounts to 0.2% of Eurozone<\/span> GDP.<\/p>\n
\n\t\tEurozone’s<\/span> help: Suffocating solidarity<\/strong><\/p>\n
\n\t\tFrom what is known:<\/p>\n
\n
\n\t\t\tCyprus will receive a loan of about half the requested size under the usual austerity conditions.<\/li>\n
\n\t\t\tThe gross public debt of Cyprus will rise from its current level of some 90% of GDP to about 140%, a level that is unsustainable and will eventually require some deep restructuring.<\/li>\n<\/ul>\n
\n\t\tThis debt trajectory is a forecast, of course, but well in line with experience.<\/p>\n
\n\t\tThe effects of this Eurozone<\/span> austerity programme<\/span> are now well known. Cyprus joins a distinguished list of countries that benefit from suffocating Eurozone<\/span> solidarity (Wyplosz<\/span>, 2011).<\/p>\n
\n
\n\t\t\tThe programme<\/span> will impose tough austerity;<\/li>\n
\n\t\t\tIts public-debt-to-GDP ratio will grow because deficits will not go away and because GDP will decline.<\/li>\n
\n\t\t\tThere will the need for more loans as economic predictions will be found to be 'disappointing' over and over again.<\/li>\n
\n\t\t\tUnemployment will skyrocket, spreading intense economic and social suffering.<\/li>\n<\/ul>\n
\n\t\tWho knows, populist parties could well be on the rise, adding political drama to economic pain. This technology is now well oiled.<\/p>\n
\n\t\tThe bank deposit ‘confiscation’<\/strong><\/p>\n
\n\t\tWhat is new is that bank deposits will be 'taxed'. The proper term is 'confiscated'. Like everywhere in the EU, bank deposits in Cyprus are guaranteed up to €100,000. Depositors have arranged their wealth accordingly, only to be told that the guarantee has been changed ex post<\/i>.<\/p>\n
\n\t\tTaxing stocks is optimally time-inconsistent (Kydland and Prescott, 1977). It is a great way of raising money but it has deep incentive effects as it destroys property rights. What is at stake is the credibility of the bank deposit guarantee system throughout Europe.<\/p>\n
\n\t\tThe system was shaken in 2008 but in the opposite direction. Followed by all other countries, Ireland offered a full guarantee in a successful effort to stem an impending bank run. The cost to the government was such that it triggered a run on the public debt that led to the second bailout after the Greek 'unique and exceptional' one.<\/p>\n
\n\t\tThat move has now been recognised as a mistake, which may explain how Cyprus is now being treated.<\/p>\n
\n\t\tThe Eurozone’s ‘corralito’<\/strong><\/p>\n
\n\t\tBecause it is time-inconsistent, the decision to tax deposits has been preceded by a freezing of bank deposits. This is remindful of the Argentinean corralito<\/i> of 2001, which led to economic dislocation, immense suffering and such anger that two governments fell (Cavallo 2011). Hopefully, the Cypriot corralito <\/i>will not last too long.<\/p>\n
\n\t\tThe question is: how bank depositors will react in Cyprus and elsewhere? The short answer is that we don’t know but we can build scenarios:<\/p>\n
\n
\n\t\t\tThe benign scenario is that depositors in Cypriot banks will accept the tax and keep their remaining money where it is. Depositors in other troubled countries will accept that Cyprus is special and remain unmoved.<\/li>\n<\/ul>\n
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\n\t\t\tA less benign scenario is that depositors in Cypriot banks come to fear another round of optimal, time-inconsistent levies. This is what theory predicts. After all, if policymakers found it optimal once, why not twice, or more?<\/li>\n<\/ul>\n
\n\t\tUnder the less benign scenario:<\/p>\n
\n
\n\t\t\tWe will have a full-fledged bank run as soon as the corralito<\/i> is lifted. Since bank assets amount to some 900% of GDP, there is no hope of any bailout by the Cypriot government.<\/li>\n
\n\t\t\tAny new European loan would immediately translate into a run on the public debt.<\/li>\n<\/ul>\n
\n\t\tEnter ECB, stage right<\/strong><\/p>\n
\n\t\tAt this point in the scenario script, the ECB enters the play. Being the only lender of last resort, the ECB will have to decide what to do.<\/p>\n
\n
\n\t\t\tIn principle, it could stabilise the situation at little cost as total Cypriot bank assets represent less than 0.2% of Eurozone GDP or 0.5% of the central bank’s own balance sheet.<\/li>\n
\n\t\t\tBut this would involve the risk that it could suffer losses – especially if the banks are badly resolved, i.e. the bankruptcies are badly handled.<\/li>\n<\/ul>\n
\n\t\tThis is not unlikely since the ECB does not control Cypriot bank resolution.<\/p>\n
\n\t\tRemember that the current version of the banking union explicitly leaves resolution authority in national hands. In Cyprus, as almost everywhere else, national authorities are deeply conflicted when it comes to their banking systems. Powerful special-interest groups become engaged when banks go bust and governments decide who pays the price. Thus, it is a good bet that Cyprus’s bank resolution will be deeply flawed. The risk to the ECB is real.<\/p>\n
\n\t\tProper resolution under European control could have been part of the conditions for the loan just agreed. But this does not seem be the case. The omission most likely reflects a belief by policymakers that the Cyprus crisis has been solved successfully. The problem is that this belief is false: Cyprus’s predicament remains even under the benign scenario.<\/p>\n
\n\t\tAll the conditions for a total disaster are in place<\/strong><\/p>\n
\n\t\tThe really worrisome scenario is that the Cypriot bailout becomes euro-systemic – in which case the collapse of the Cypriot economy will be a sideshow. This will happen when and if depositors in troubled countries, say Italy or Spain, take notice of how fellow depositors were treated in Cyprus.<\/p>\n
\n\t\tAll the ingredients of a self-fulfilling crisis are now in place:<\/p>\n
\n
\n\t\t\tIt will be individually rational to withdraw deposits from local banks to avoid the remote probability of a confiscatory tax.<\/li>\n
\n\t\t\tAs depositors learn what others do and proceed to withdraw funds, a bank run will occur.<\/li>\n
\n\t\t\tThe banking system will collapse, requiring a Cyprus-style programme that will tax whatever is left in deposits, thus justifying the withdrawals.<\/li>\n<\/ul>\n
\n\t\tThis would probably be the end of the euro.<\/p>\n
\n\t\tConclusions<\/strong><\/p>\n
\n\t\tThe likelihoods of these three scenarios – benign, less benign, and total disaster – are difficult to assess.<\/p>\n
\n
\n\t\t\tWhat is clear is that the Cyprus bailout has created a new situation, more perilous than ever before.<\/li>\n
\n\t\t\tOnce more a deeply dangerous policy action is decided apparently without any awareness of its unintended consequences.<\/li>\n<\/ul>\n
\n\t\tIt is also another violation of sound existing arrangements. We have a no-bailout clause in the Maastricht Treaty – a clause that was essential to the Eurozone’s stability. Putting it aside in the case of Greece was the heart of the today’s problem – the reason the crisis spread (Wyplosz 2010). This no-bailout clause has once again been put aside summarily.<\/p>\n
\n\t\tWe are now witnessing another radical change as a perfectly reasonable deposit guarantee is being undermined. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors.
\n\t\t <\/p>\n<\/div>\n
\n\tCharles Wyplosz<\/span><\/strong> is Professor of International Economics at the Graduate Institute, Geneva, where he is Director of the International Centre for Money and Banking Studies. Previously, he has served as Associate Dean for Research and Development at INSEAD<\/span> and Director of the PhD program in Economics at the Ecole<\/span> des Hautes<\/span> Etudes en Science Sociales<\/span> in Paris. He is a CEPR<\/span> Research Fellow and has served as Director of the International Macroeconomics Programme<\/span> at CEPR<\/span>.<\/em><\/p>\n
\n\tAll views expressed are the author's and not by association FNArena's (see our disclaimer).<\/em><\/p>\n
\n\tRepublished with permission from the publisher. Copyright VoxEU.org – the above story was originally published on www.VoxEU.org – readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) – here's a link to the original story on the VoxEU website: click HERE<\/a><\/em><\/p>\n
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