Why Cyprus's awful bank deposit tax will leave a lasting scar

Banking is a confidence trick. The modern financial system – fractional reserve banking as it’s technically called – relies on the public putting faith in their banks. After all, the nature of the system is that at any one time there’s never enough cash in bank vaults to give everyone their deposits back – which is why bank runs are so fatal.

That’s why in financial crises the cardinal rule is always to attempt to reassure savers that their deposits will be safe. It’s why we have things like deposit insurance; it’s why all Northern Rock, RBS etc savers were made good during the crisis in the UK. Yes, everyone ended up having to pay the eventual price anyway through austerity and higher taxes but people are accustomed to having money confiscated through income and consumption taxes: their savings, on the other hand, are considered inviolable.*

And that is, when push comes to shove, the problem with the way the Cyprus bailout and bank deposit tax has been handled. If you have money in a bank account – any bank account – in the country, you are being hit with an instant and unavoidable tax. This instantly undermines public faith in banks – not just the rotten ones but every single branch in the country, including branches of perfectly healthy foreign banks.

This is worth reiterating because there are some analysts who, in economic terms at least, can’t see that much of a problem with the bank deposit tax. After all, the country is in need of a bail-out; the money has to come from somewhere; the banking system is full of dirty Russian money, so why not start there? And in economic terms, this is quite right: plus you avoid all the messy legal complications of defaulting on bondholders. Moreover, technically speaking depositors are just another lender to banks, alongside creditors.

But looking at this through an economic prism misses the point, which comes back to that fragile confidence trick. There are of course certain circumstances under which a bank’s depositor should lose out: basically when that bank collapses. Indeed, that’s precisely the kind of system we need in future to prevent bail-outs and too-big-to-fail.

However, in those circumstances 1) other senior creditors should lose out, 2) depositors whose savings are below the deposit insurance scheme limit should be protected and 3) the deposits affected should, logically, be in the bank that’s going under.

None of these three criteria were observed in the Cyprus case, where even deposits in Barclays in Cyprus are subject to the tax, in the plan’s initial form. It doesn’t take a genius to figure out that such a capricious attitude to principles savers might have reasonably considered inviolable will catastrophically undermine Cypriots’ faith in banks – not just Cypriot ones but any within their country.

There is a chance I’m wrong about this – after all, as I’ve said above, in blunt economic terms it doesn’t really matter where Cyprus gets its bailout cash – whether from taxpayers, depositors, fiscal cuts or the Germans – it still needs money to pay the bills. But the experience of the 1930s showed that when a government intervenes to confiscate deposits, it critically undermines that faith in the banking system.

And, for better or worse, that faith is a key bedrock of the modern capitalist economy. Would that it weren’t the case: but it is. And what’s happening in Cyprus begs profound questions about whether there really is a safe place to put one’s cash, questions which can now legitimately be asked about all banking systems, not just in Spain, Italy and so on, but also in the UK and the US.

That is why the initial plan being passed around Brussels spared deposits below €100,000. The eventual scheme, involving a tax on all savers, came as a complete surprise to anyone who wasn’t in the room when it was being hammered out.

What, after all, is sacred? We used to assume insured deposits were. Now we can no longer be sure.

* I’m talking, of course, about the savings themselves rather than the interest on the savings – there’s less of a cultural resistance to taxing that.