Measures being pursued by the Eurozone to force bank depositors in Cyprus to pay for the bailout of their country marks a new unfortunate twist in the financial crisis and one that ultimately could spell the doom of the euro itself.
Banks are crucial to the functioning of an economy and once they cease to function so does the economy. Yet Eurozone policy makers with the support of the International Monetary Fund are pursuing moves that further endanger the already fragile financial systems of peripheral Eurozone countries.
Avoiding the specter of bank collapses, which are often preceded by runs on deposits, has been one of the cornerstones of banking regulation since the Great Depression of the 1930s. Depositors in the Eurozone generally have believed their money to be safe in banks, but after the raid on Cypriot savers many are having doubts, particularly in peripheral Eurozone countries.
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The next time a Eurozone country looks likely to need rescuing, such as the much larger Spanish and Italian economies, the most logical step for depositors in those countries will be to withdraw their money from banks as fast as they can to avoid the fate of Cypriots.
Some depositors are no doubt already withdrawing funds and this is no doubt why the U.S. dollar, British pound, Swiss franc and gold have been rising against the euro recently. In effect they are benefiting from capital flight from the Eurozone or at least the anticipation of it happening.
If bank depositors in other peripheral Eurozone states decide to react by withdrawing funds, it will deeply complicate any rescue efforts. The European Central Bank's yet to be tapped Outright Monetary Transactions (OMT) program is designed to stabilize prices of peripheral Eurozone sovereign bonds, should they face a sell-off.
If that's accompanied by bank runs, a manageable crisis could escalate to levels that even the ECB, the Eurozone and the international community will struggle to contain in a globalized financial system prone to domino effects. Under such circumstances, capital flight out of the Eurozone could be intense, which could see the euro plunge across the board and may require external help from countries such as the United States, China and Japan to stabilize it.
A dangerous new dynamic
Eurozone leaders have injected a new negative dynamic into the Eurozone crisis and could cause further disparities in interest rates paid by banks and other borrowers within the Eurozone – a situation the ECB has been keen to avoid.
Bailing out Russian crooks who keep money in Cyprus might well be distasteful to other Eurozone countries, but they should have let common sense prevail. Instead there is now the far worse alternative of adding further complications to the Eurozone crisis, which could lead to bank runs, sovereign bankruptcies and exits from the euro.
If the Cyprus situation does evolve into a wider crisis of confidence in the Eurozone, it may force yet more integration at breakneck speed. A strong Eurozone wide depositor protection scheme and unified banking regulation may now be needed to counteract worries over bank runs, although it would be deeply unpopular in the more prosperous northern countries.
If these confidence sapping actions aren't addressed, future historians may come to view measures to tax Cypriot savers as a milestone toward the demise of the Euro itself.