The Risks of The Cyprus Levy

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    By Jacob Taylor

    The Republic of Cyprus has become the latest nation to suffer a debt crisis. In the simplest sense, Cypriot banks have incurred so much debt that creditors have become convinced that they will be unable to pay off any additional loans. Since the banks depend on loans to pay the interest on already standing loans, this cutoff puts them at risk of bankruptcy or default.

    Many other nations, including the United States, have faced similar crises in recent years. Without support, insolvent banks are forced to declare bankruptcy sell their assets in order to pay off the debt. Since the bank will have already paid out everything else, its only remaining assets include savings and investment accounts. If your bank goes bankrupt, your savings vanish. Most nations have some sort of depositor insurance that protects savings, up to a point. In the US, personal savings are protected by the Federal Deposit Insurance Corporation, up to 250,000 dollars. So, if you have 1,000,000 dollars saved in a bankrupt bank, you effectively lose 750,000 dollars.

    Such a loss, multiplied by millions of savers, would be devastating to an economy. Worse, there is the “too big to fail” principle. Some banks are so large that their national insurance program would be unable to cover savers losses in the event of bankruptcy. Such an event would cripple investment in the nation, consumer spending would collapse and unemployment would skyrocket. Social unrest would be soon to follow.

    Somehow, the insolvent banks must receive financial assistance in order to pay off all or most of their debt. Usually, the national government finances such a bailout. Unfortunately, the Cypriot government does not have enough money to bail out its banks. Like Greece, Cyprus has turned to the European Central Bank in search of a bailout package. In the past, the Eurozone nations have been willing to pay for such assistance in order to avoid the ripple of a member default. However, there are stipulations that come with such support. Generally, the suffering nation is required to accept a plan that will enable it to pay for as much of the bailout as possible. Greece was forced to enter into social austerity and the money saved supported their bailout package. These plans are also designed to prove the ailing nation’s commitment to ensuring the sustainability of its spending and borrowing practices.

    In the past, austerity measures have been used as the primary form of repentance in exchange for financial salvation. However, the Central European Bank (ECB) has demanded a new and all but unused measure to solve the Cypriot crisis. The current deal, as agreed to by the Cyprus Finance Ministry, calls for a 6.75 percent levy on all savings accounts of 20,000 to 100,000 euros. All accounts in excess of 100,000 euros are to be subjected to a 9.9 percent levy. For the sake of clarity, this effectively means that a savings account in Cyprus with exactly 1,000,000 euro in it before the levy will be reduced to 901,000 euro. At the time of writing, this proposal has been met with public outrage and was unanimously rejected by the Cypriot parliament.

    A great many ideas and theories must have led to the proposal of the levy plan. Many of them, such as the presence of Russian mob money in Cypriot banks, are specific to the Cyprus crisis itself. Others relate to political pressures in other Eurozone nations, such as Germany.  However, I want to discuss how the economic understanding of personal savings influences these and other decisions.

    Saving money, while prudent on an individual scale, is a huge problem for macroeconomics. Given the choice, many economists will agree that the economy is better off if people invest and consume as much as possible. Such activity stimulates economic growth which raises wages, profits, and the quality of life for all. Saving money stops those good things from happening. Curiously enough, this is one of the arguments behind supporting higher taxes. A responsible person or company will always divide their money between consumption and saving. If you have 1,000,000 dollars; you may only spend half of it. The rest is left to rot in a savings account. The government does not save. If the government has 1,000,000 dollars; it will all be consumed. It might not be consumed efficiently or effectively, but it will all go back into the economy somehow, thus stimulating growth.

    Periods of economic decline are often attributed to excessive saving. During a downturn, people save their money in order to build their safety net. Because less money is being spent, businesses take in less revenue. Less revenue means less investment, lower wages, and less employment. As wages fall and jobs are lost, people save even more. This cycle, without outside interruption, theoretically continues until the entire economy grinds itself to a standstill.

    It is from this logic that the origins of the Cyprus bailout plan start to make more sense. The continuing recession can be, at least partially, attributed to the process described above. Policy makers around the world have been striving to dislodge the savings blockage and force people to spend more money. This is the thinking that drives government stimulus packages, bond purchases, and tax hikes. The goal is to get the money out of the bank and into the market. In the case of Cyprus, I imagine part of the thinking to fall along the following lines: government programs, like the ones that were cut in Greece, contribute to economic growth. Savings accounts contribute little to nothing to the economy. Since, without the bailout, they will be obliterated anyway; why not levy them for the good of the nation?

    Ignoring any moral or philosophical issues, there is a glaring practical problem with this plan. The only reason that the Cypriot banks have not been completely emptied already is thanks to a bank holiday that has been in place since last week. If the precedent is established that nations can directly levy personal savings accounts, worldwide savings will plummet. Any citizen who is at all concerned about their nation’s financial situation will transfer their savings from a bank account to their mattresses in order to avoid the possibility of a levy. Mattress money deteriorates with inflation and contributes even less to the economy than savings deposits. Furthermore, such sudden withdrawals could accelerate the maturation of a debt crisis in vulnerable but currently solvent nations. Such an event would almost certainly extend the global recession for years, if not decades to come.

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