More on Cyprus

Ok, so why is the deposit tax on deposits under 100,000 euro a terrible idea? To understand this, we have to look at what Europe has been going through for the last decade or so. Basically, in the early 2000’s (after the creation of the Euro-zone), private capital from the Euro-core (Germany, France, Holland, etc) began flowing to the periphery of the Euro-zone. This is likely because debt issued by countries in the periphery was paying a much higher rate of interest than debt in the core—EU banking regulations placed no limit on the amount of sovereign debt that banks could buy, and private lenders assumed that the European Central Bank (ECB) would never let a member of the euro-zone default. So, to banks in Germany and France, sovereign debt issued by the peripheral countries looked like a safe bet that paid a much higher interest rate than debt from the core countries, and because there was no limit to the amount that they could purchase, they bought a lot of it. The influx of private capital in the periphery drove down interest rates and sparked lending booms; in Greece the government just racked up tons of debt; in Spain, Portugal, Ireland, and Italy, budget deficits were actually low and public finances were in good shape. However, the lowered interest rates led to private sector booms (ie the housing bubble in Spain) and sparked inflation. Of course, because monetary policy weighted inflation by GDP (and none of the peripheral countries’ GDP came close to that of Germany or France), monetary policy never adjusted to tamp down the inflation in the periphery. This led to lower economic competitiveness in the periphery as wages and prices rose disproportionately quickly. All of this came crashing down in 2008 as the global financial crisis caused many of the bubbles to burst; this led to bailouts of private institutions, recessions, and growing public debt in peripheral countries—some of them (Greece, Ireland, Portugal) were in such bad shape that the government needed outside assistance.

At this point, the core EU countries (but primarily Germany), faced a choice: either the taxpayers in the core EU countries could bail out the periphery, or Greece, Ireland, etc. could default on their debt, leave the Euro, and begin printing their own currency again. Unfortunately for the core EU countries, single currency areas are prone to self-fulfilling financial contagion. For example: As a starting point, let’s assume that most people in Europe would think it is unfathomable that a country could leave the Euro (indeed, there is no legal or technical mechanism in place that would allow this under current law). Even if a country were in such bad shape that it might be better served to leave the Euro, default, and start printing its own currency again (Greece), many Europeans likely never considered the possibility that Greece could leave the Euro. Of course, if Greece were to then actually leave the Euro, all of a sudden depositors/creditors in Spain, Italy, Portugal, Ireland, etc. begin to wonder if their money is safe in those countries. Just to be safe, they start pulling their money from peripheral banks and depositing them in German banks—all of a sudden, balance sheets in Spain start to look pretty bad; lending slows down, the economy grinds to a halt; government finances take a turn for the worse as tax revenues fall in the recession and so on and so forth. In essence, by allowing one country to leave the currency area when no one thought that would be possible, the EU could set off a financial panic whereby even safe countries with good banking systems and sound public finances come under a lot of pressure (basic bank-run dynamics here).

Since that would obviously be bad for everyone involved, the core EU countries decided to move ahead with bailing out the peripheral countries. As an added bonus, the Euro-zone added a deposit insurance scheme backed by the ECB that fully guaranteed the safety of all deposits up to 100,000 Euro. Thus, a depositor in Spain could rest easy that even in the case of a bailout, their money (up to 100k) would be safe; this takes a lot of the pressure off of the self-fulfilling currency crisis dynamics–so, by undermining the deposit insurance by taxing deposits under 100,000 euro, the Cyprus bailout is sort of putting the entire European financial rescue project in jeopardy (to placate taxpayers in the core that don’t want to bail out what they see as profligate peripheral euro countries).

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