The big news in economics this week is the proposed bailout of Cyprus. In brief Cyprus is having difficulties paying it's debts and requires an influx of cash from the rest of the EU to prevent a collapse. Negotiators arranged a deal in which in exchange for a ten billion euro cash influx and debt reduction Cyprus would impose a one time tax on deposits held at Cyprus banks.
I've spoken with a number of my peers as well as searched extensively online for anyone willing to argue for the plan. Unfortunately, if anyone outside the creators of the deal are willing to support it they're doing it very quietly. Therefore although I do not believe the bailout package to be either well thought out or efficacious I will attempt to argue it's merits before discussing why it's ultimately foolhardy.
Undoubtedly one point of consideration during the construction of the bailout was that the EU (and Germany in particular) will not agree to pay for the spending of troubled nations indefinitely if those nations do not demonstrate some effort to pay first themselves. A deposit tax will clearly show the people of the more affluent nations that the citizens of Cyprus are paying their fair share as well. There's a lot of merit to this idea. German taxpayers are likely to be less resentful that their taxes often are being used to refinance other nations debts if they can see those nations are suffering as well. After all no one wants to feel like they're the only ones suffering, especially if they feel like they're innocent of causing any of the current difficulties.
Additionally a deposit tax will hit the Russian affluent disproportionately harder than an average Cyprus citizen (in terms of raw euros lost). Cyprus is often used as a tax haven for wealthy Russians, who generally hold much larger accounts than an ordinary citizen. The deal called for these larger accounts to be taxed more heavily, whereas accounts under a hundred thousand euros were taxed at a lesser rate. To the elite of the European Union this must have seemed like free money. Take just a little from the people of Cyprus and get a lot from Russia (that isn't even an EU member). If you can take Russia's money to pay for your financial difficulties why not do it?
Finally, there must have been some rationalization that the money wasn't actually being stolen as depositors would be compensated with bank shares. The fact that these banks are on the verge of financial ruin clearly just slipped someones mind.
So there's the best case I can build for why such a plan was a good idea. Now here's the much easier case for why it would have been disastrous.
It wouldn't have worked and it would have (and did) instill additional uncertainty in an EU that is just starting on the road to recovery.
Let's imagine for a moment we're a depositor at a bank in Cyprus. Monday morning we wake up and find that the banks are unexpectedly closed. Further, when we check the news we learn that the government has a plan to take between 6% and 10% of our money without substantial compensation. The next day the bank opens and we're able to withdraw our funds if we so wish. What would your course of action be? I know I'm probably moving my money someplace where I can be sure I'm not going to have to tithe involuntarily. The only bright side is that when the inevitable run on the bank occurs we can be sure everyone will be able to get back 10% of what they deposited... since the banks took that from them the day before. Unfortunately the other 90% is probably gone forever. It's a pretty good plan to take a bank from the edge of collapse to actual collapse, but not a very good method for salvaging a failing economy.
What amazes me the most about the whole situation is the potential cost/benefit of the plan. Cyprus is a tiny tiny portion of the EU economy. Yet for some unknown reason negotiators drafted a plan that would spur doubt in the safety of bank deposits throughout the continent. Letting Cyprus collapse and withdraw from the Union would have been more damaging only in the sense that it would have cause an even larger media storm than this bailout package. In actual economic terms it would have been nearly unnoticeable. The scale of the problem is so small that it is amazing to me that the Troika didn't simply slap together a package, slip it to Cyprus under the table to keep them going for another year and then deal with it later when the European economies were under less scrutiny.
Politically it's a wonder anyone thought such a plan had a chance. Not a single legislator voted in support of the plan. A wise choice if they hoped to remain a legislator for very long. Unsurprisingly the bailout package is widely unpopular in Cyprus as well as many other nations which fear such a precedence.
I seriously question the wisdom of whoever constructed such a plan. However, undoubtedly it was the product of a bureaucracy which warped and twisted many good ideas into what was ultimately an ineffective and foolhardy result. Luckily the bailout package has been rejected. Unfortunately that leaves Cyprus still on the verge of collapse and no closer to a solution.
More economics news next week be it political or academic. Until then stay safe and rational.