Banks got bailed out, and Cypriots got sold out—almost. Last weekend, the 1.1 million citizens of the tiny island nation learned that even savings accounts arent safe. The European Union and the International Monetary Fund, seeking to keep the country in the euro system, offered a €4.2 billion ($5.5 billion) bank bailout, but with one major condition: Cyprus would have to raise €5.8 billion on its own, for a total of €10 billion. Center-right president Nicos Anastasiades agreed, proposing a levy on bank deposits—one that would fall not only on the wealthy, but also on the life savings of the working class, in the form of a 6.75 percent tax on deposits of less than €100,000. Families with less than €10,000 in savings would have to fork over €675. But notwithstanding the agreement Anastasiades made, members of Cypruss parliament voted down the plan Tuesday.
That Europe—that is, the European Commission and the European Central Bank—agreed to this idea shocked just about everyone. The proposed tax on guaranteed bank deposits is the type of measure that makes people rush to buy gold bars. Cyprus isnt some Third World nation, where residents must constantly worry that the government will grab their assets, as Argentina did five years ago when it nationalized $30 billion in private pension savings. Cyprus is a member of the common euro currency. Like all European nations, Cyprus offers a version of FDIC-style deposit insurance for people with under-six-figure savings. If you put a modest amount of money in a Cypriot bank, youre supposed to be able to rest easy, knowing that your savings are safe, should the bank fail.
Analysts who insist that Cyprus is too small to set a precedent are missing the point. If this can happen in one euro nation, it can happen in any. Yes, Cyprus is unique. Because Russians use it as a tax haven, its banking system is eight times the size of its domestic economy. And Cypriot banks invested heavily in Greek debt and lost big when the EU allowed Greece to default on that debt two years ago. Nevertheless, like Ireland in 2010, Cyprus now faces a choice between letting its large banks fail or taking European bailout money that comes with harsh conditions.
The harshest new condition is German. Facing political pressures, Chancellor Angela Merkel wont approve Irish-style bank rescues that dont include some kind of loss on the part of bank investors. Small bank depositors learned last weekend that Europe includes them in that category. And with Cyprus banks closed on Monday for a Depression-style bank holiday, they would have no chance to act on this new information before seeing a chunk of their money removed from their accounts.
Depositors in countries such as Spain and Italy would be wise to take heed: if theyre next in line for bailouts, they could suffer, too. From the perspective of a finance-ministry bureaucrat, local depositors are stuck with nowhere else to go. Large depositors and bondholders, by contrast, have plenty of global choices about where to park their cash. Cypruss government leaders used exactly that logic in proposing to force small depositors to take losses along with large depositors and junior bondholders (but not senior bondholders).
Forcing small depositors to suffer may make bailout-weary Europeans feel good, but it does nothing to correct the problem that caused the financial crisis in the first place. Sophisticated large investors, perceiving that Western governments will bail them out when they get in trouble, continue to lend too much money, too cheaply, to Western financial institutions. That Europe would let one of its member countries punish unsophisticated savers in order to limit losses for larger depositors and senior bondholders only solidifies this perception.
The message official Europe sent to global investors this week was this: The Continent is so desperate to protect senior creditors to the ostensibly private financial system that it will let even poor people take a hit. The related message was that the idea of even a small banks going bankrupt terrifies the E.U., for fear of what such an event would do to the financial system. If last weekends proposal went through, senior bondholders could have rested easy. Thats why what happened Tuesday, when the parliament rejected the presidents deal, was a heartening sign for global financial recovery. Not one parliament member voted yes; the members of the governing party abstained. This repudiation sends Cyprus, and perhaps the rest of Europe, to look for a different solution.
In voting down an arbitrary, confiscatory tax, Cypriot lawmakers stuck up not only for their constituents but also for the principle of investor discipline. Merkel and the rest of European officialdom should start doing the same.