The Cyprus Breach

Stocks around the world reacted negatively to the proposal by Cyprus government to impose losses on depositor in order to bail out the two most troubled banks. Here is just one report from the Wall Street Journal:

U.S. stocks followed overseas markets lower as a Cyprus bank-deposit tax sparked renewed fears about Europe's debt crisis.

The Dow Jones Industrial Average was down 38 points, or 0.3%, to 14376 in midmorning trading. The Standard & Poor's 500-stock index dropped eight points, or 0.5%, to 1553 and the Nasdaq Composite Index shed 16 points, or 0.5%, to 3233.

The euro tumbled versus the dollar. The price of the 10-year U.S. Treasury note surged as investors sought haven assets, pushing the yield down to 1.949%. 

So far the US investors have acted more nonchalantly than their Asian counterparts where Nikkei closed down 2.7% and Shanghai was off by 1.7%.  We may casually dismiss the importance of Cypress as an economy, but the coherence of the world today owes more to ideas than machinery. When the government of Cypress acquiesced to the German demand that depositors pay part of the bail out, it breached an idea that the governments around the world have instilled within the financial world since the days of great depression. idea is bank deposits are absolutely safe.

The widespread adoption of fractional banking system has provided ample fuel for the modern economy. The strength of such system lies with its ability to increase money supply and provide additional capital for your hungry entrepreneurs. As the Greeks had noted long time ago, the strength of most things also tended to be their inherent flaw. In a fractional banking system, no bank can meet the demand of redemption if sufficient depositors demanded them simultaneously. This flaw proved fatal for a large number of banks during the great depression. Even since then, government deposit insurances have propped up in various forms to protect depositors during time of distress. After 75 years, the disease of run on the bank has virtually been wiped out. So we thought.

The Cyprus Breach has once again raised the specter of bank run. If the Cyprus levy was indeed implemented, what is to prevent the depositors from taking their money out after the pilferage on the vary rational thought that this may not be a one time deal? What is to prevent depositors from yanking their money out of Spanish or Italian banks on the possibility that such practice may eventually be applied to them as well?

The Euro is now at a crossroad. The German's desire to punish the irresponsible is certainly understandable. However, the choices before them is either to shoulder the entire responsibility of bailing out their less assiduous brethren or time to declare failure on the Euro experiment.

The Cyprus decision will be a big deal.