The madness of the bailout in Cyprus

Wait a second. So I lend you a thousand dollars, for a nice interest rate.

Then you go bankrupt or just disappear.

And in this dire situation I should not be allowed to collect $1 from a thousand random citizens to compensate my loss?

What an absurd concept.

Yeah, you're right, the tone is unhelpful.

My point is that there's nothing you can do with your money to ensure that it always has value, regardless of the magnitude of the crisis. There's always some risk. You can store your money in insured bank accounts, but we can see how well that's working out in Cyprus. You can store cash under your mattress, but high inflation will destroy its real value. You can buy gold and hoard it in your home, but there's no guarantee gold will be worth much, or that you'll even be allowed to keep it (see Executive Order 6102). You can buy land and if the state fails and thugs with bigger guns decide they want it more you're screwed. There's nothing you can do to eliminate all risk, and we're seeing now that risks we though were minimal (failures of deposit insurance schemes in the western world) aren't so minimal after all.

Your understand is wrong in practice. In fact a recent example in the US is the MF Global fraud. That is why there is the SIPC http://www.sipc.org/How/Brochure.aspx it's like the FDIC except for losses related to fraud surrounding the failure of a brokerage firm.

When a sovereign fails, its banks fail, and private sector losses are virtually assured. The question is who bears the burden. Roughly half the deposits in Cypriot banks, with assets five times its GDP, are of Russian, Greek, or British origin [1]. They were attracted by high deposit rates (roughly double EMU average) and a system tolerant of likely tax evaders.

>"This whole thing is entirely unfair for the people living in Cyprus. The average citizen had nothing to do with the banking sector stocking up on Greek debt, but now they have to pay for it."

Foreign deposits are flighty. The loan-for-austerity solution is too slow. The Cypriot financial minister has already noted "substantial outflows" from banks over the past few weeks [2]. Announcing a future tax would leave the burden exclusively on ordinary Cypriot depositors. This measure was intended to help the Cypriots, not burn them.

Further, the mark-downs on Greek debt is a proximal, but not the root, cause of the problem. The IMF warned Cyprus in 2011 to raise capital levels, potentially by slashing deposit rates - it did not. Ratings agencies chimed in, in 2012, that private sector losses would result if Cyprus did not increase contributions to bank capital. Complicating the situation is that 15-20 percent of Russian bank capital and nearly 10 percent of Russian corporate deposits sit in Cyprus - there was probably external pressure to keep the banks leveraged.

Pre-crisis, Cyprus stood out for its high growth (almost 4%) and low unemployment (low of 3.6% in 2008), despite a falling savings rate, rising labour costs, and a red hot real estate market following its accession into the eurozone in 2004 [3]. Today, we have a zero growth economy with a banking crisis that would have tipped its debt/GDP from 87% to 145%.

Cyprus needs a capital injection equal to half of GDP. This was never going to be painless.

>"So what do investors, businesses, and savvy savers do? They pull their money from banks in the troubled euro countries. No need to take the risk, even if it’s small."

This is unlikely - the EU banking environment is already highly re-patrimonialised. Non-financial corporate and high net worth deposits have already fled to the degree that they can. Domestic depositors are, for better or worse, less flighty (and savvy) than senior bank debt investors - hence the logic for preserving their latter at the expense of the former. Also Cypriot banks have very little senior bank debt (0.3% of assets for Laiki [4]). This is cruel, yes, and I sound with The Economist's criticism of the tax levied on minor accounts (those holding less than €100 000). But forced de-leveraging will be cruel.

Given the political constraints from Deutschland limiting the ability of the European Central Bank to launch into Fed-style monetary base expansion and its Landesbanks preventing euro-wide deposit insurance, the bank regulatory constraints imposed by a country relying on flighty deposits for financial stability, and the economic constraints of a highly-indebted nation in the middle of a geopolitical brouhaha between Greece, Turkey, and Russia slated for near zero growth in the near future, this is not a terrible deal. Note that Iceland, which was in a similar position in 2007, saw its economy crater by nearly 1/3 from 2007 to 2011, or about 9% annually. Peak (2007) to trough (2009), 3/5.

[1] http://blogs.ft.com/beyond-brics/2013/03/13/russias-cyprus-p...

[2] http://www.ft.com/intl/cms/s/3/83fb0dd2-8802-11e2-b011-00144...

[3] https://www.imf.org/external/pubs/cat/longres.aspx?sk=25382.... 2011 Cypriot IMF Article IV Consultation

[4] http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-...