The resolution of the Cyprus banking collapse paves the way for more crises

To read the headlines, it sure seems like the crisis in Cyprus has been contained. In the wake of the announcement last week that large depositors would lose a big chunk of their savings, there have been no large-scale bank runs and no riots. Life on the island and in Europe is proceeding as usual. In the U.S., the stock market hit new highs.

But it’s way too soon to celebrate. And given Europe’s brazen mismanagement of the Cyprus debacle, the euro crisis once again moved closer to becoming a serious problem for all of us. The Cyprus rescue broke new ground. Beyond inflicting losses on investors in ailing Cypriot banks, Eurozone governments for the first time imposed a new penalty on some of the depositors in all of the island’s banks. This represents new and dangerous territory for the European banking system and, through it, for our own economy as well.

Over the past three years, as global investors have periodically fled the government bond markets of Greece, Portugal, Ireland, Spain and Italy, Eurozone leaders have provided $650 billion in bailouts. For the last year, the European Central Bank has also stepped in to shore up the government bond markets of beleaguered Eurozone nations. Sure, the troubled member-countries have had to accept drastic austerity programs, which generally have only worsened their economic condition. But the whole point of these costly exercises has been to protect the solvency of European banks, including many of the leading banks of Germany and France. They, after all, are the ones that hold most of the bonds of the troubled countries. And if those banks go down, they could take the world economy with them.

Yet, last week, when the two major banks in tiny Cyprus needed a modest bailout of $13 billion to hold the Eurozone together, European leaders suddenly departed from their protect-the-banks-first philosophy. In addition to the usual austerity, they proposed a new tax or “haircut” on all Cypriot bank deposits. The people of Cyprus, and their elected representatives, declined this unrefusable offer. So, last Tuesday, Eurozone finance ministers came back with a revised proposal—only large depositors, those with more than 100,000 euros, would have to take a loss. In short, they threw away the EU pledge of deposit insurance, which is the last defense against nationwide bank runs.

This populist take on punishing only large depositors for a bank’s reckless behavior doesn’t change its larger implications. The next time global investors lose confidence in the bonds of, say, Italy or Spain, those countries’ banks will quickly face waves of withdrawals by their large depositors. That would almost certainly sink those banks and quite possibly trigger broader bank runs. So, ironically, the new policy could help bring on the kind of far-reaching financial crisis which the bailouts were designed to head off.

From the vantage points of Berlin and Paris, the new deal is appealing in broad, crude political terms. European voters get the satisfaction of forcing the well-heeled depositors of failing banks to pay a price, along with those banks’ investors. In the case of Cyprus, many of those depositors aren’t even Eurozone citizens: They’re hyper-rich Russians, including a host of oligarchs who looted much of the Russian economy in the 1990s and then shifted their proceeds to foreign accounts. They didn’t choose the banks of Cyprus banks for their investment expertise, since the bankers sunk much of those deposits into Greek sovereign bonds, which turned out to be among the world’s worst investments. Rather, they chose Cyprus because it’s a traditional tax haven with very low taxes and strict bank secrecy laws. Old times also may also have played a role with the oligarchs, since Cyprus had long been a favorite KGB listening post on the Middle East.

The global economics of the deal, however, are simply terrible. Large depositors account for a tiny fraction of all Cypriot bank accounts, but more than half of all Cypriot bank deposits. It’s much the same everywhere, including the United States. Here, bank accounts of $250,000 or more account for less than one-half of one percent of all bank accounts, but nearly one-quarter of all bank deposits. In normal times, our own deposit insurance limits the amount subject to its guarantee at $250,000. But when confidence in banks is fragile or failing, the government always steps in to guarantee all deposits. That’s what the Treasury and FDIC did in September 2008, to prevent a run on American banks by large depositors that would have spread the crisis across the U.S. banking system. That unlimited guarantee remained in place until our financial system was stable and healthy, ending only at the end of 2012. The best way to stop a bank run, it turns out, is to insure deposits.

Eurozone leaders are ignoring these basic tenets of deposit insurance. Instead, they have telegraphed to large European depositors that even in a financial crisis, large accounts are no longer safe. So, the next time global investors begin selling off, say, Italian or Spanish government bonds, threatening the solvency of the banks holding those bonds, we could see a run by large depositors not only in Italy and Spain, but across Germany and France as well. And that would set off a new financial crisis that could trigger a downward spiral here and across much of the world. So far, markets have not responded much to this new risk. But global investors will remember if the extended downturn in Europe brings on renewed government bond problems in Italy or Spain.

This is not the only example of inane economic policy thinking these days. New York Times columnist Paul Krugman last week defended capital controls—which have been put in place in Cyprus—because he believes the movement of funds in and out of national markets can destabilize economies. But the issue here is not the easy movement of funds across global markets. In fact, those capital flows have been a key factor in the only good economic news of recent years—the strong performance of many developing economies and our own renewed economic stability. No, the problem lies in what financial institutions do with those funds and the reluctance of governments to enforce sensible limits on them. In the end, the spectacular stupidity of Eurozone leaders last week is only the most recent and dangerous example of how politicians can willfully ignore the most obvious and important economic points.