Eurozone's risky strategy in Cyprus - opinion

Cypriots are outraged by leaders' attempts to tax their deposits as part of a bailout for the tiny nation.

NEW YORK (CNNMoney)

They take out a revolver, load a bullet into one chamber, spin it, aim for their head, and pull the trigger. It doesn't fire, so they celebrate for a while, and then decide to try it again ... with the same result.

After repeating this a few times, they become convinced that it will never fire.

(This is not intended as an assertion of American superiority, since our politicians seem prone to similar behavior with our budget problems.)

The eurozone's latest gamble is on Cyprus.

They have chosen to call into question the security of bank deposits in the eurozone, including insured deposits, rather than take a more politically difficult, but safer, step.

European leaders hope to minimize the damage by convincing depositors in other troubled nations that actions taken in Cyprus would never be applied elsewhere.

Cyprus truly is unique in important ways, but depositors and citizens elsewhere will note that the eurozone's leaders have now shown a legally easy way to destroy the value of deposit guaranty insurance, along with a willingness to use that approach under at least some circumstances.

Related: 5 reasons the Cyprus bailout matters

This is a foolish thing to do, because there are more bank deposits in the eurozone than government debt, meaning that the potential problems of contagion are very large. There may not be any bank runs in other nations in the near term, but I fear this action will have a large effect in any future bank crisis.

The eurozone's leaders believed, perhaps accurately, that there were no politically feasible alternatives.

The best solution would have been a eurozone rescue on fairly lenient terms, as at least an interim solution. The country is very small; its economy is only about 0.5% of the total eurozone. A pragmatic rescue would have paid dividends in increasing the euro area's stability at a critical time when problems in Greece, Italy, Spain and elsewhere are worsened by political constraints created by the run-up to Germany's September federal elections.

Unfortunately, the Cypriot banking system is too closely associated in the minds of Germans and others with Russian oligarchs and mobsters using the island for tax evasion and money laundering.

So, it appears the eurozone's leaders believed there could be no rescue without sharing the pain with Cyprus or Russia. The Russians appear likely to help, but not in a big enough and public enough way to solve the eurozone's political problem.

Related: Cyprus shuts banks as bailout backfires

Imposing losses on the holders of Cypriot government bonds would have achieved the political purpose, but doing this earlier in Greece was disastrous and the eurozone's leaders have rightly sworn that this will not happen again during the current crisis. For their part, holders of bank bonds will almost certainly take losses, but there happen to not be a lot of Cypriot bank bonds, so more money was needed.

That left the depositors to make sacrifices.

Eurozone leaders were well aware that forcing losses on depositors of struggling banks would increase the risk of bank runs in other troubled countries if the public started to lose confidence in their finances.

Yet they saw no other politically feasible solution, so they tried to be clever. They chose to impose a uniform tax on depositors of all banks, rather than a haircut related to the size of each bank's losses.

Presumably, that was to avoid the precedent of depositor losses by framing the action as a one-off wealth tax, but it is hard to believe anyone but lawyers will make the distinction in applying the lesson to other situations.

There is a grave risk that this action will eventually lead to serious bank runs in other parts of the eurozone.

A depositor in a weak country with a troubled banking system would have to seriously consider moving their funds to a stronger country, which is easy to do within the eurozone, or out of bank deposits altogether, which is even easier.

European leaders can repeat until they are blue in the face that the unique circumstances of Cyprus are the only reason they went this way, but many depositors will focus on the fact that even insured deposits are being hit. Nor is the relative health of one's bank relevant to the loss, so it will not necessarily be better to hold deposits in a safe bank.

The eurozone keeps gambling on risky, politically expedient solutions to deal with the problems that are directly in front of it.

Sometimes this has worked and sometimes, as with the Greek bond haircut, the longer-term consequences are disastrous. The eurozone may get lucky this time, either because the euro crisis is near its end or because there will be no further bank panics.

However, I fear neither of those fortunate situations will prove to be true.

Douglas J. Elliott, who worked as an investment banker for two decades, is a fellow at the Brookings Institution.

First Published: March 19, 2013: 12:18 AM ET

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