European policymakers work in strange and mysterious ways. Over the past year, they bent many rules and threw literally hundreds of billions of Euros at Greece to prevent that country from exiting the Euro. They did so for fear that a Greek exit might cause contagion to other countries in the European periphery. And then over this last weekend, they chose to spook financial markets and risk the very contagion that they sought to avoid in the Greek case, by demanding that as part of its bailout package Cyprus imposes a tax on bank deposits.
The only way that Europe’s seemingly irrational policy prescription for Cyprus can be explained is that it was the result of a political compromise. In anticipation of German elections scheduled for September 2013, Mrs. Merkel, the German Chancellor, had to assure her electorate that German taxpayer money would not be effectively used to bailout the Russian oligarchs who have large deposits at the Cypriot banks. She did so by demanding that at least EUR5.8 billion in Cyprus’ bailout package came from a tax on bank deposits. For his part, Mr. Anastasiades, the new Cypriot president, fearful of unduly antagonizing the Russians, felt that he could not have all of the tax on depositors fall on the large depositors. For this reason he agreed to tax small depositors as well.
Whatever the reasons for the decision to have Cyprus tax small depositors, it sets a dreadful precedent for the rest of Europe. No longer can depositors in Italy, Portugal, and Spain feel secure that their deposits are safe from confiscation in the event of the need for an IMF-EU bailout package. This must be expected to accelerate capital flight from these countries to safer havens both within and outside of Europe. And such capital flight will only complicate the European crisis down the road.
It might also be noted that the Cypriot debacle is not occurring in isolation. Rather it is occurring at a time that Italy is in the midst of a serious and prolonged political stalemate, Spain and Portugal are plunging ever deeper into recession, and Greece is already missing its IMF revised tax revenue targets. Anyone who still thinks that the Euro crisis is over is simply not paying attention.