The Cyprus precedent

After 12 days, Cyprus' banks reopened last Thursday with strict controls limiting how much of their cash people could withdraw or transfer abroad.

The sun-washed Mediterranean island is the latest country caught in the rolling wave of the European crisis. While its financial sector had grown overleveraged, what tipped it over the edge was the Greek bailout. Cypriot banks were heavily invested in Greek bonds, and when that country's bailout cut the value of those bonds, Cyprus' banks found themselves suddenly critically ill.

A rescue was urgent. But bailout-weary European partners demanded that Cypriots bear the bulk of the expense. They recommended that rich depositors' money in Cypriot banks be 'bailed in' - which is to say, the government would skim off some of the funds and use them to help pay the bill.

But the Cypriot financial system has come to depend heavily on the deposits of Russian oligarchs. The government did not want to alienate them, for fear they'd all pack up and leave and decimate the financial system. So it proposed to spread the pain widely, taxing all accounts - even those of small savers under the 100,000-euro threshold which Europe's deposit-insurance scheme guarantees as safe.

SHAKY FOUNDATION

Call it a bail-in, a tax, seizure or theft: from the point of view of savers, it amounts to the same thing. As one wag in the business press commented, it's a good time to buy shares in mattress-making companies, because everyone will now be rushing to hide their savings there.

It bears repeating endlessly: the modern financial system is built entirely on trust. Few currencies are now backed with any kind of hard asset, like gold, and very little money even takes the form of paper notes. It's little more than digits in cyberspace, which we can exchange for goods and services. But if people start to believe those digits can suddenly vanish, the system's foundation will become shaky.

That's why Europe's leaders felt it was so important to preserve the trust of ordinary people by only bailing in depositors over the insurance threshold. They satisfied themselves that because the policy finally adopted does this, bank runs will not spread beyond Cyprus.

They reckon that the rich, those whose deposits exceed the insurance threshold, appreciate that banks offer a service, but not a guarantee. Rich depositors, who will now lose a substantial chunk of their investments, supposedly know this and hedge against potential losses. Indeed, in the weeks leading up to the policy announcement, rich Russians, with ears to the ground and friends in high places, had started quietly moving their money out of Cyprus, and into the US. So in theory, rich depositors are aware of the risks they're taking, and roll with the punches.

LIMITING CONTAGION

In theory. In practice, although European leaders insist the Cypriot case is exceptional, they may find it hard to limit contagion. Since there are other small European countries with exceptionally large financial sectors, like Slovenia and Luxembourg, rich depositors may quietly start runs there as well.

More to the point, the strict limits on the movement of funds, including limits on bill payments and credit cards, are going to affect ordinary people negatively. We all think of our money in the banks as ours, available when we need it. Should the perception emerge that putting money in the bank may put the funds off-limits, people will hold back more cash. Haul out those mattresses.

If the flow of funds into the banking system diminishes, that will, in turn, constrain economic activity. Europe's leaders will have to convince the rest of the world that there is a firewall around Cyprus, and that what happened there won't be repeated elsewhere. But a precedent has been set. If it is repeated, it will become a new norm. And if it becomes a new norm, the contagion effect could be as serious as it was in the 2008 crisis. Europe's recession would then morph into a depression.

John Rapley, a politicaleconomist at the University of Cambridge, is currently on a visiting professorship at Queen's University in Canada. Email feedback to columns@gleanerjm.com and jr603@cam.ac.uk.