Last on Cyprus

Vox came out yesterday with an article arguing that the tax on deposits, while not necessarily fair to depositors, is not the danger to financial stability that many have argued it is.

First, the argument that ‘Cyprus is different’ is quite persuasive. Cyprus is a small country with an outsized banking system created via lax regulation. Second, the deposit tax is an efficient way of “bailing in” foreign creditors, given the high share of non-resident deposits. Third, and perhaps most importantly, I believe Italian and Spanish savers are already aware that they are subject to their own sovereign risk: when a country falls under severe budgetary stress, income and savings are at risk as governments try to shore up public finances…Italians will also still remember the precedent of an extraordinary tax on bank deposits in 1992, though of a much smaller magnitude (0.6%)… Finally, the ECB has been crystal clear in its commitment to avoid systemic instability in the Eurozone, and could step in to calm any signs of excessive anxiety in other Eurozone members.

While I don’t think it is by any means certain that floating the proposal to tax deposits under 100,000 Euro will incite financial instability, I think this article understates the risk of that possibility for several reasons. First, Cyprus isn’t an isolated incident: granted, yes, the devil is in the details (this proposal wouldn’t be an issue if the bank liabilities were more concentrated in bonds and less concentrated in deposits), but this is now the third European island nation to allow its financial sector to balloon to many times GDP, putting the country’s economy and fiscal state at risk. I agree that the deposit tax is an efficient way to raise the needed revenue given the specifics of the banking system, but that is no reason to violate the intent of the deposit insurance by taxing deposits under 100,000, especially if the revenue could be raised entirely through taxing uninsured deposits.

Moving on, preserving the sanctity of the deposit insurance is important precisely because Italian and Spanish savers are aware that they are subject to sovereign risk. I think one could argue that given this awareness of the risk of depositing money domestically, the deposit insurance up to 100,000 would take on an even more important role–the whole point of the insurance is that while future income may be subject to higher taxes, past savings up to 100k are safe. Violating that principle in Cyprus certainly could change the calculus for folks in Spain and Italy.

Last, the ECB has indeed made a clear commitment to do its best to avoid systemic instability in the Eurozone; the statements and actions of Mario Draghi played a huge role in tamping down panic in the summer/fall of 2012. Of course, a commitment is only effective so long as it is credible–given the ECB’s actions with respect to the situation in Cyprus, I am not so sure how credible the ECB’s commitments to the Euro are: the ECB has made it clear that unless Cyprus accepts the bailout terms of the EU loan (a proposal which, until Tuesday, contained a levy that violated the intent of the EU’s deposit insurance scheme), the ECB will cut off emergency liquidity to Cypriot banks.  I think that if Cyprus refuses to accept the EU bailout and the ECB stops lending to Cypriot banks, financial contagion could easily spread across the Eurozone periphery, in which case the ECB would have been an instigator of, not protector against, financial instability. Granted, this is a low-probability outcome, but if the ECB is truly committed to reducing financial panic in the Euro periphery then perhaps engaging in brinksmanship at the height of a financial crisis is not the best course of action.

With that said, I still think the situation will be resolved over the next few days–my guess is that Cyprus will come to its senses, agree to a deposit tax that preserves deposits under 100k in their entirety, and the ECB will continue lending to distressed Cypriot banks. However, I think the way that this situation was handled by the EU, ECB, and IMF might have ramifications for the next time a crisis pops up in Europe (does anyone doubt that will happen at this point?)

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