Legislators in the tax-haven island of Cyprus have rejected the draconian bank deposit tax defying German leader Angela Merkel. While the protestors danced in the street after the vote, this could be a pyrrhic victory. President Putin threatened to withdraw a $3.2 billion loan if the Merkel proposal were embraced, a condition that might have influenced the final tally.
The Merkel-backed measure, tied to the bailout of Cypriot banks in virtual insolvency, called for a tax between six and ten percent on all deposits. Nearly half of these deposits are from foreigners, mostly Russians, seeking to take advantage of low taxes and lax banking laws on the island.
Merkel had noted that if her measure were not approved further financial aid from Germany would not be forthcoming. She drew a line in the sand that is sending shock waves across Europe and into Wall Street investment houses.
If Cyprus can oppose this wealth transfer plan what would happen in Greece, Spain or Portugal facing similar tax measures? European Union officials claim the situation in Cyprus is idiosyncratic. Very few financiers believe them. The levy not only infuriated Putin, but sent a lightning bolt through the island where there is likely to be a run on the banks. It is true Cypriot banks have a reputation for attracting money launderers and notorious tax cheats, but the precedent of taxing bank deposits is having a chilling effect on E.U. banks. Alas, this is a slippery slope that could lead to bank failures in Spain and Italy and beyond.
The tiny island of Cyprus is not the end of this story. Cypriot banks are loaded with bad loans made to Greek companies and unsavory Russian oligarchs, but they are not alone. Many European banks are in a parlous state. However, taking the money of ordinary depositors, billed as a tax, is unprecedented. By any reasonable standard, this practice is robbery.
Moreover, despite efforts to contain the Cypriot disease, the E.U. is caught in the cross-hairs. Merkel's credibility is at risk and the prospects for the survival of the union have grown very grim indeed. Although it has yet to occur, a bank run in the euro zone is a distinct possibility. If you are a pensioner living on a fixed income, your first inclination would be to get your money out of the bank before the government takes a portion away.
What happens next is not clear even if a bailout from international creditors is put in place. Presumably, the euro zone will wait for a counter proposal from the Cypriot government that will place strict control on money transfers. But even with this bailout, Cyprus could face a collapse of its banks, an event that could be the thin edge of the wedge forcing Cyprus out of the E.U. and signaling others on the same path to dissolution.
Many analysts contend the direct effect of the Cyprus bank collapse would be insignificant given the size of the island and the magnitude of aggregate loans. Overlooked, however, is the precedent that may be established and the symbolic influence on the E.U. Cyprus may be described as a "special case," but in reality, it is less special than many experts think. Bank insolvency is a continental issue. And if truth be considered, the inextricable ties among banks make this debt question a global issue. A sneeze in Cyprus could be a full-blown flu in Europe and pneumonia in North America.