The extreme dangers of a deposit tax

Reuters

Article Highlights

  • Crisis in Cyprus has important global implications.

    Tweet This

  • Deposit tax is a bad idea in Cyprus--and anywhere else.

    Tweet This

  • Economic crisis in Cyprus shows US what not to do.

    Tweet This

Subscribe to AEI's international economy emails
Articles and events on international economic policy. Published approximately once a month.

First Name:
Last Name:
Email:
Zip Code:

The banking system in Cyprus remains in a state of crisis, only narrowly avoiding collapse through a recent agreement between the nation and the European Central Bank (ECB), European Union (EU), and International Monetary Fund (IMF)—the “Troika.” The €10 billion rescue package includes the condition that Cyprus come up with a portion of the rescue funds through a tax—now called a "restructuring"—on deposits over €100,000 in the nation’s banks. Such a tax cripples Cyprus's banks and frightens depositors in other debt-laden weak economies like Greece, Spain, Portugal, and Italy. Once again the Troika has doubled down on a losing bet to rescue the eurozone from a breakup. They fail to acknowledge that Cyprus and Greece cannot be in a currency zone with Germany, Holland, and Finland, and the Troika tax only underlines this fact.

 

Key points in this Outlook:

  • The Troika (EU, ECB, IMF) restructuring of Cyprus’s two major banks leaves them still facing insolvency. The Troika’s €10 billion rescue package in exchange for what amounts to a multibillion-euro tax on depositors in Cypriot banks sets a bad precedent.
  • The Troika tax will intensify the loss of confidence in Europe’s already shaky banks, especially in Portugal, Spain, Italy, and Greece.
  • The Troika tax fiasco in Cyprus will undercut the viability of recession-weakened banks across Europe. Nations should attempt to reassure their citizens of the security of their bank deposits if they hope to rebuild their economies.

Seemingly minor events can have huge consequences if they embody the elements of systemic problems that trigger panic. In June 2007, two small Bear Stearns real estate hedge funds failed, producing temporary headlines that led to dismissals from “informed” and “official” sources of any underlying significance of the event. Nine months later, in March 2008, Bear Stearns failed. Six months later, Lehman Brothers collapsed, ushering in the financial crisis that nearly imploded the global financial system.

The Bizarre Crisis in Cyprus

Fast-forward five years: in March 2013, after providing hundreds of billions of euros in bailouts to prevent Greece from exiting the eurozone, for the sake of “European solidarity,” the European Central Bank–European Union–International Monetary Fund, or Troika, euro-rescue team agreed to provide Cyprus’s two large and insolvent commercial banks with a €10 billion “rescue package.” The Troika rescue team required the Cypriot government to contribute to the bailout with a combination of levies on junior bond holders and, incredibly, a €5.8 billion restructuring tax on depositors in Cypriot banks. The finance ministers of the EU and the ECB, together with the IMF, told the new Cypriot president, Nicos Anastasiades, that absent the deposit tax, those two banks would be allowed to fail, wiping out their €68 billion in deposits (nearly four times Cyprus’s €17 billion-plus GDP), of which €42 billion (nearly 2.5 times the GDP) were held by Cypriots and €26 billion by foreigners (figure 1).

The foreigners are largely Russians who have found Cyprus’s banks a convenient place to park—and perhaps to launder—excess cash. The much-emphasized fact that Russians are substantial depositors in Cyprus’s banks is largely a red herring, however. The tax on deposits is the main issue.

The Troika’s willingness to provide hundreds of billions of euros during 2010–12 to bail out Greece while denying Cyprus €10 billion to rescue its two banks is, beyond being bizarre, ironic for at least two reasons. First, the Troika's provision of financial life support for Greece has been a spectacular failure, with the economy and the stock market in a state of collapse, engendering near anarchy for beleaguered Greek citizens. Secondly, the Greek collapse caused the insolvency of Cypriot banks that had invested heavily in Greece, especially after Cyprus joined the European Monetary Union in January 2008.

Cyprus is a victim of the Troika’s unsuccessful rescue effort in Greece that gave it loans in exchange for austerity—more taxes and less spending. So harsh was the austerity imposed upon Greece as a condition for bailouts that output and tax revenues have collapsed, leaving Greece’s debt-to-GDP ratio even higher than it was before the Greek crisis erupted in 2010 after the late-2009 revelations that the Greek government had been faking the numbers on its deficits and debt.

Cyprus Deposit Tax Crisis Is Dangerous

The crisis surrounding tiny Cyprus carries with it dangerous systemic risk implications. At the heart of a financial crisis is a loss of confidence in the ability of depository institutions (banks) to honor the claims of their depositors. Bank depositors (households and businesses) normally see their deposits as safe, highly liquid assets—that is, as money. People normally hold money to pay bills and to deal with unexpected emergencies like doctor and dentist bills and car repairs.

"The crisis surrounding tiny Cyprus carries with it dangerous systemic risk implications."

In times of crisis, people demand more cash in the face of more uncertainty and as a way to store more wealth safely, a notion encouraged by deposit insurance (up to $250,000 per account in the United States and up to €100,000, about $130,000, in Europe, including Cyprus). “Safe and sound” are the watch words that banks use to attract deposits.

During the US financial crisis, the Federal Reserve constantly emphasized the safety of bank deposits. Banks borrow from depositors on special terms that specify that such funds are always available “on demand.” These terms contrast with the arrangement offered to banks’ other lenders: holders of bank bonds and equity. Theirs is risk capital, the value of which may change along with the fortunes of the bank. In the presence of market and economic risks, depositors, especially those with deposit insurance provided by the government, are supposed to be protected. Above the insured level, large deposits are employed as a safe haven by households and businesses with large payments to make. In short, they are part of the money supply.

After the Lehman collapse, when banks faced skittish large depositors (those with deposits over the $250,000 insurance limit), to assure the safety of their deposits and to avoid hasty withdrawals that could precipitate a liquidity crisis, the federal government offered insurance on all deposits in special accounts that paid zero interest. This unlimited deposit insurance was deemed necessary for firms whose payroll accounts often held tens or hundreds of millions of dollars to make timely payments to employees. The special insured deposit accounts also accommodated nervous corporate treasurers and wealthy individuals looking to store cash during a period of substantial instability that included concerns—in some cases, well-founded—about the solvency of some major banks.

The special accounts were quietly ended in December 2012, producing a large flow into Treasury bills, viewed by many as a safe haven. Like special deposits, their yield is virtually zero, but this does not concern those with large cash holdings who are looking for a safe place to store wealth in an uncertain world. It is little wonder that interest rates on short-term, low-risk Treasuries are miniscule and even those on long-term Treasuries—say, 10-year notes—are only 1.9 percent.

Risk-averse investors, whose numbers grow during and after financial crises, are looking for a return of capital rather than a return on capital.

Getting to a Bank Run

Given the critical “safe haven” quality of cash largely composed of bank deposits, suppose a plausible rumor emerges tomorrow that budget negotiators are about to propose—not yet pass into law—a 10 percent tax (about the size of the Cyprus tax) on all bank deposits. It would be obvious that, were the tax enacted, households with $100,000 in the bank would “pay” a tax of about $10,000 that would simply be deducted from their account and credited to the account of the US Treasury.

"Risk-averse investors, whose numbers grow during and after financial crises, are looking for a return of capital rather than a return on capital."

Such confiscation would occur before the announcement of a tax in order to preempt any rush to avoid the levy. The prospect that the federal government was going to confiscate 10 percent of Americans’ cash assets with a wealth tax would obviously stir up fear among US depositors. This is exactly what has happened in Cyprus.

The US M2 money supply (cash, demand deposits, money market deposit accounts, savings, and small-denomination time deposits) totals about $10.4 trillion, about $1.1 trillion of which is cash and therefore not trapped in banks to be taxed under a deposit tax. The US tax base for the deposit tax is therefore about $9.3 trillion, give or take small numbers for special accounts. A 10 percent “one-time”—what they promised in Cyprus—tax would yield $930 billion, nearly $1 trillion for federal coffers. That is enough to more than fund the entire 2013 federal budget deficit, currently estimated to be $845 billion.

For beleaguered budgeteers, especially for Democrats looking for revenue drawn from “the rich” to fund more spending, a 10 percent deposit tax is a dismayingly tempting option. But, in reality, it is a disastrous idea that fortunately could not be implemented in the United States without causing a financial panic that even President Obama and Senate Majority Leader Harry Reid (D-NV) might notice. The experience of Cyprus, not to mention basic economic theory, history, and common sense, explains this consoling reality almost in full.

Consider the behavior of bank depositors upon hearing a rumor of a 10 percent tax to be levied on those deposits. Most would rush to withdraw their funds from the banks. A run on the banks would occur almost instantly that would drain bank reserves and force bank closures like those being imposed on dismayed Cypriots in the immediate aftermath of the deposit tax announcement.

Deprived of any funds once they had run through cash holdings held outside of banks, businesses and households would cease making payments. Actually, that would occur immediately because without access to banking funds, cash hording would soar.

If this were to happen in the United States, the sudden freeze-up of the American financial system would collapse the American economy, not to mention the global financial system and the global economy. Surely the possibility of such an outcome is sufficient to quell even hints of consideration of a deposit tax by the Congress or the White House. Even revenue-hungry Democrats do not want to be saddled with the responsibility of collapsing the global financial system. Such a tax in Cyprus would be less catastrophic for the global financial system than a deposit tax in the US would be, but it still has far-reaching economic implications.

Why the Tax on Bank Deposits in Cyprus?

Given the extremely dangerous and costly outcomes following the imposition of a deposit tax, why would Europe’s leaders, who have spent trillions of euros protecting the confidence in Europe’s shaky banks, risk a collapse for the sake of saving €10 billion in aid to Cyprus? We are told the answer lies with German politics. German Chancellor Angela Merkel, facing an election in September, has run up against the limits of German patience with bailouts.

Therefore, to provide Cyprus with loans to rescue its banking system, the German government, Europe’s paymaster, required the stringent conditions of a €10 billion contribution from Cyprus to the bailout. The decision, apparently made through Germany’s finance ministry, to require a Cyprus restructuring (deposit tax) is dismaying because it underlines the complete insensitivity of major European policymakers to the danger of risking a run on banks outside of Cyprus, especially in southern European countries like Italy and Spain—not to mention Greece, where the solvency of the banking system continues to be in question.

Although the spread of the Cyprus bank run to southern Europe and beyond will probably be preempted by reassurance and plenty of cash from the ECB, the Fed and other central banks will not find their jobs made easier by the Troika’s colossal blunder in imposing the deposit tax in Cyprus and setting a dangerous precedent underscored by numerous newspaper and television images of Cypriots lined up outside of shuttered banks.

Why, we must ask, would the Troika bailout meisters scare banks depositors worldwide at the very time when they should be reassured that there is some safe place to store assets in a very risky world? If you want depositors to take on the risks borne by supposedly more sophisticated investors in bank bonds and equity, why tax their deposits? That is fraud, plain and simple.

There may be a silver lining in the Cyprus-eurozone deposit tax fiasco. If the situation reveals the immense dangers that can follow from bank runs triggered by rumors of deposit taxes, governments may be moved to publicly, collectively, and unambiguously eschew the deposit tax as a revenue source.

Let us hope so.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

John H.
Makin

What's new on AEI

Making Ryan's tax plan smarter
image The teacher evaluation confronts the future
image How to reform the US immigration system
image Inversion hysteria
AEI on Facebook
Events Calendar
  • 01
    MON
  • 02
    TUE
  • 03
    WED
  • 04
    THU
  • 05
    FRI
Wednesday, September 03, 2014 | 9:00 a.m. – 10:30 a.m.
From anarchy to Augustus: Lessons on dealing with disorder, from Rome’s first emperor

We invite you to join us for two panel discussions on how Augustus created order from chaos 2,000 years ago, and what makes for durable domestic and international political systems in the 21st century.

Wednesday, September 03, 2014 | 12:00 p.m. – 1:30 p.m.
Multiple choice: Expanding opportunity through innovation in K–12 education

Please join us for a book launch event and panel discussion about how a marketplace of education options can help today's students succeed in tomorrow's economy. Attendees will receive a complimentary copy of the featured book.

Thursday, September 04, 2014 | 12:00 p.m. – 1:30 p.m.
How conservatives can save the safety net

Please join us for a luncheon event in which our panel will discuss what conservatives can learn from how liberals talk and think about the safety net and where free-market economics, federalism, and social responsibility intersect to lift people out of poverty.

No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.