Every so often, a moment comes along when you learn something important about how economies work. Thanks to the Euro area member states, we’re about to get one of these moments. Next week, we’re going to find out how people react when their bank deposits are at risk of being confiscated.

English: (Green) Cyprus. (Light-green) The Eur...(Photo credit: Wikipedia)

Faced with the prospect of having to lend €17 billion to Cyprus to bail out its banks, the Euro area member states had three choices: Lend all this money but have Cyprus default on its existing sovereign bonds, lend all the money on terms that make it clear you’re not getting it back or lend less money and let the banks default on their obligations.

Cypriot banks are closed on Monday for a scheduled holiday but we will find out on Tuesday whether people are willing to keep their money in bank accounts in a country that occasionally imposes “one-off stability levies” – most things that people claim are one-off aren’t.

The more interesting question, however, is how will depositors react in the rest of the Eurozone.  There will undoubtedly be promises that this is the only country in the euro area that will write down deposits but promises from European politicians don’t mean much.  They insisted for ages that a default in Greece was “not an option” but it happened and Cyprus’s own finance minister dismissed the idea of a depositor haircut only a few days ago saying  ”Really and categorically – and this doesn’t only apply in the case of Cyprus but for the world over and the euro zone there really couldn’t be a more stupid idea.”  Well maybe but it’s a stupid idea whose time has come.

How will depositors in Spain react next week? Everyone knows the Spanish banks are sitting on large unrealized losses and that, sooner or later, these banks will have to be dealt with. Now that people know that a depositor haircut is part of the European toolkit for dealing with banking problems, why would you sit around and wait for it to happen to you? This decision has the potential to trigger a full-scale bank run across the euro area and such an outcome could place in question the continued existence of the euro as a common currency.

However, we simply don’t know whether depositors will react at all. Up to now, despite clear evidence that large corporations have tended to move their money out of crisis countries, we haven’t seen much evidence of ordinary retail investors wanting to move their money out of bank accounts in Europe’s periphery (though the Northern Rock incident in 2007 shows that this can happen).

Personally, I’ve been surprised at how many people have kept their money in retail bank accounts in Greece.  You can also ask why people still had their money in Cypriot accounts this week even with newspaper headlines suggesting this levy was one of the options being considered.

So it may be that nothing happens because people believe the politicians about Cyprus being a one-off or else simply don’t know enough to realize their money is at risk.

Still, the Cyprus deal is structured in way that is likely to maximize potential concerns elsewhere. As this option was being discussed in recent weeks, a common theme was that this levy shouldn’t worry European depositors because Cyprus was a sui generis problem: Its banks were stuffed with deposits from Russian oligarchs of dubious moral repute and there was no question of ordinary depositors taking a hit.

But the decision to tax all deposits below €100,000 shows that ordinary Cypriots are going to be hit very hard by this plan.  And the fact that Cyprus’s small amount of bond creditors are being left untouched is likely to deepen the perception of unfairness. (You really have to wonder why they couldn’t have implemented a plan that raised the same amount of money but exempted all deposits below some threshold amount, thus protecting people who don’t have much wealth).

One way or another, next week will tell us a lot about the willingness of European retail depositors to keep calm and carry on in the face of worrying developments.

Even if we get through the next week without panic, my gut feeling is that this decision is a bad one and the Europeans should have chosen from the other two options on the table.  Over the longer-term, I doubt if financial stability in the euro area (and the continued existence of the euro) is compatible with a policy framework that doesn’t protect the savings of ordinary depositors


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