By Prof. Charles Wyplosz
The decision to tax all Cypriot bank deposits has attracted massive attention (Spiegel 2013) ? and rightly so. It is a huge blunder:
- In the unlikely event that all goes well, the government will receive a bit of cash ? but not enough to cover the loan generously offered by its European partners ? and the Cypriot banking system will be history.
- The alternative is a massive bank crisis in many Eurozone countries ? a huge blow to the euro, maybe even a fatal one.
Not an emergency measure
Policymakers have been debating the Cyprus bailout for nearly a year; this cannot be classified an 'emergency action'. They engaged in a lively debate whether Cyprus is 'systemic' or not, the answer to which can only be 'it depends'. It depends not on the size of Cypriot banks but on the way the Eurozone acts. They also debated the Russian deposits that apparently represent a sizeable proportion of bank liabilities. The debate turned around the issues of how dirty this money is and how to do the laundry. They also debated on the size of a possible loan to the Cypriot government. The government itself requested something to the tune of 100% of its GDP, why not? After all this amounts to 0.2% of Eurozone GDP.
Eurozone's help: Suffocating solidarity
From what is known:
- Cyprus will receive a loan of about half the requested size under the usual austerity conditions.
- The gross public debt of Cyprus will rise from its current level of some 90% of GDP to about 140%, a level that is unsustainable and will eventually require some deep restructuring.
This debt trajectory is a forecast, of course, but well in line with experience.
The effects of this Eurozone austerity programme are now well known. Cyprus joins a distinguished list of countries that benefit from suffocating Eurozone solidarity (Wyplosz, 2011).
- The programme will impose tough austerity;
- Its public-debt-to-GDP ratio will grow because deficits will not go away and because GDP will decline.
- There will the need for more loans as economic predictions will be found to be 'disappointing' over and over again.
- Unemployment will skyrocket, spreading intense economic and social suffering.
Who knows, populist parties could well be on the rise, adding political drama to economic pain. This technology is now well oiled.
The bank deposit 'confiscation'
What is new is that bank deposits will be 'taxed'. The proper term is 'confiscated'. Like everywhere in the EU, bank deposits in Cyprus are guaranteed up to €100,000. Depositors have arranged their wealth accordingly, only to be told that the guarantee has been changed ex post.
Taxing stocks is optimally time-inconsistent (Kydland and Prescott, 1977). It is a great way of raising money but it has deep incentive effects as it destroys property rights. What is at stake is the credibility of the bank deposit guarantee system throughout Europe.
The system was shaken in 2008 but in the opposite direction. Followed by all other countries, Ireland offered a full guarantee in a successful effort to stem an impending bank run. The cost to the government was such that it triggered a run on the public debt that led to the second bailout after the Greek 'unique and exceptional' one.
That move has now been recognised as a mistake, which may explain how Cyprus is now being treated.
The Eurozone's 'corralito'
Because it is time-inconsistent, the decision to tax deposits has been preceded by a freezing of bank deposits. This is remindful of the Argentinean corralito of 2001, which led to economic dislocation, immense suffering and such anger that two governments fell (Cavallo 2011). Hopefully, the Cypriot corralito will not last too long.
The question is: how bank depositors will react in Cyprus and elsewhere? The short answer is that we don't know but we can build scenarios:
- The benign scenario is that depositors in Cypriot banks will accept the tax and keep their remaining money where it is.