- - Thursday, March 28, 2013

There is a deal in place that will bail out the government of Cyprus — but only after extracting more than $5 billion from bank depositors and plunging the economy into uncertainty. It virtually guarantees the island nation will stay in the recession that has been plaguing it for the past six quarters. The implications for savers in a world filled with revenue-hungry governments are even more ominous. The just-concluded deal taxes bank deposits heavily, forcing savers to pay for the government’s profligacy and lenders’ cupidity.

Savers are already being pummeled across the world by low interest rates, creeping inflation or both. A direct tax on deposits will further reduce the incentive to save. Punishing thrift is an entirely counterproductive strategy for a country struggling to get back on a growth trajectory. This is the direction, though, the world seems to be drifting — from tiny Cyprus to the mighty United States — with all the ill that portends for the future.

The current crisis in Cyprus was fueled not just by the large holdings of Greek bonds by the domestic banking sector, but also by excessive government spending, which currently sucks up 45 percent of gross domestic product. With those bills coming due soon, and inadequate resources to pay them, Nicosia sought to avoid a default by seeking a bailout from the troika: the European Commission, the European Central Bank and the International Monetary Fund. Nicosia was hoping for the same kind of “help” received by neighboring Greece. It got it, and now will pay the price. The current deal effectively ends Cyprus‘ role as an offshore banking center and wipes out a critical sector of its economy.

The previous proposal visualized a tax on all depositors. Deposits under $130,000 would have been subject to a 6.75 percent tax, and larger deposits would have been trimmed by almost 10 percent. That proposal was resoundingly rejected by the Cypriot parliament, in a vote that sent shock waves through the European Union. The uncertainty it triggered resulted in the Nicosia government imposing controls in an effort to stop depositors from taking their money and running to safer havens.

With its persistent need for financing, Nicosia accepted a new deal from the troika. The revised proposal will keep deposits below $130,000 safe. The extent of loss from larger deposits, which totaled $49 billion prior to these negotiations, is not clear, but could reach 40 percent of their value. The deal requires restructuring in the financial sector, as the weak Laiki Bank will have to close, while its good assets are absorbed by the Bank of Cyprus. The bank restructuring is expected to yield some $5.4 billion, which the troika demanded as a condition for extending a loan of $13 billion.

This was substantially lower than the original bailout package of $23 billion sought by Nicosia, which makes up a tiny fraction of 1 percent of the EU’s economy. The terms enforced are far harsher than in the previous four bailout packages, and were intended to wipe out the country’s offshore banking business. There was an underlying assumption that much of the money in the large deposits was Russian, and possibly, from illicit activities. Such depositors have few alternate secure banking options, and the fact that they are relatively unworthy of sympathy also make them an easy target.

None of this is good policy. Cyprus had plenty going for it. It was a relatively free economy, with a low corporate tax rate of 10 percent and substantial business freedom. The profligacy of its government and the irresponsibility of borrowers — both government and in the banking sector — have succeeded in eliminating the very economic features that could have returned Cyprus to a growth path. It now is stuck with crippling public debt, the kind of uncertainty that investors hate most, and capital controls that make it an unattractive destination for the financial assets it attracted in the past.

The Cyprus deal tried to tax foreign savers to bail out domestic borrowers. Now those savers will look for safer havens. The problem is that the Cyprus deal shows that while some destinations might be safer, there is no truly safe haven for savers. While the tax on saving is explicit in Cyprus, it is more subtle here in the United States, where federal funds are used to bail out banks. From taxes to inflation, saving seems to be increasingly a sucker’s game in which even the wealthy can mooch off taxpayers and the thrifty. If enough people start acting rationally on this realization, economic collapse can happen anywhere. Penalizing saving is a dangerous game: Eventually, everyone loses.

Nita Ghei is policy research editor with the Mercatus Center at George Mason University.