Cyprus and Germany are playing chicken—and so far, nobody is blinking. On Saturday, the European Central Bank, IMF and European Commission demanded a wealth tax on all deposits in Cypriot banks as a precondition for a bailout of Cyprus’s banking system. On Tuesday, the Cypriot parliament rejected any haircut on depositors. Yesterday morning, the ECB said that if no deal is reached by Monday, it will stop all Emergency Liquidity Loans to Cyprus and without that credit line, the two largest banks in Cyprus will collapse. Today, the Cypriot parliament is scrambling to come up with a solution but with the ECB position hardening, a compromise might not be found. In that case, Cyprus will almost certainly be forced out of the euro, making the 6.75 per cent haircut first proposed on deposits under €100,000 look generous. Cypriot savers will lose much more if they leave the single currency, but so will German workers. So will the entire world economy.
The intransigence shown by southern debtors and northern creditors this past week suggests that even if a solution is cobbled together, the euro crisis is far from over. We have had a few tranquil months since last summer, when Mario Draghi, president of the European Central Bank promised, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This guarantee of unlimited firepower reassured markets, drove down borrowing costs for the PIIGS (Portugal, Ireland, Italy, Greece and Spain) and greatly reduced the likelihood of exit from the euro. If Cyprus leaves, all that optimism will dissipate, perhaps to be replaced by a self-fulfilling expectation of dissolution. We could see the single currency divide into two blocks: one of northern creditor nations and the other of southern debtors. The southerners will see the value of their savings evaporate as their currencies depreciate, but the upright northerners will also suffer as their currency grows stronger, lowering demand for their exports and so forcing up unemployment. Everybody loses.
The threat of mutually assured destruction usually prevents disaster, but there are exceptions. With the stakes so high, it is shocking that not a single member of the Cypriot parliament voted to permit any levy on depositors, even if those under €20,000 were exempt. It is also shocking that the ECB took the risk of sparking bank runs throughout the southern periphery by demanding contributions from depositors whose accounts had been guaranteed. Both creditors and debtors in the euro crisis are becoming more self-righteous and more convinced of the other’s perfidy, insistent on imposing more costs on counterparties and fewer on themselves. Even if a compromise is found by Monday, this newfound intransigence does not bode well for the single currency or the next time a debtor requires a bailout.
This crisis should remind us of something obvious we always forget. A bank statement is little more than an IOU, backed by nothing but the bank’s word. When we deposit money into our bank accounts, we think we are just placing it under a more convenient mattress, but actually we are lending that money to the bank. Your deposit becomes the bank’s liability—money it owes you and promises to repay upon demand—but like any loan, there is the possibility the debtor won’t have the cash when you ask for it and will default.
Before the Great Depression, everybody knew this. That’s why bank runs and so bank collapses were relatively common back then. Deposit insurance has been a tremendous boon, allowing ordinary depositors to be confident their money was safe. The ECB has said that the proposed haircut on guaranteed deposits in Cyprus was a one-off but by ignoring this guarantee even one time, they have made bank runs in Spain, Portugal and Greece much more likely. Bad move. It would be tragic if the single currency finally falls apart over a mere €5.8bn.