The Cyprus government and the European Union are trying to reach a “deal” still as I write this.  The original proposal was for a bailout of Cyprus, but in exchange, the Cyprus government would seize the money of all depositors in Cyprus banks, from 6.75% to almost 10%.

As I pointed out, this is just a direct way of taking the people’s money.  The same thing happens in the United States and elsewhere, but just in a more underhanded way.  The U.S. uses the Fed and monetary inflation to accomplish the same thing.  It is just that the seizure of savings happens to everyone, not just bank depositors.  It happens to anyone holding U.S. dollars.  It is more spread out and it is done in a hidden way, but the results are similar.

The one result that is different is the reaction of the people.  In Cyprus, the people started protesting en masse because of this proposal for a one-time seizure or tax.  Yet these same people never revolt against the government that wastes far more resources in less than a year’s time.

The other interesting thing is that depositors in Cyprus banks have done quite well up until last week, earning high interest rates (to reflect the risk).  Peter Schiff wrote a nice article explaining the irony.

When the people protested and the Cyprus legislature originally backed down, some politicians were criticizing the people saying that it was being done for their own good.  How many times do we hear this from politicians?  But in this particular case, I almost wonder if it isn’t true.  Most of the people in Cyprus would lose 6.75% of their bank savings.  The higher rate would only apply to people with far more wealth, most of whom are Russians.

So the Cyprus government and the Cyprus banks would get a massive bailout (relative to the size of the country) and most people would still have over 93% of their bank savings left.  But if the people revolt so much that they force their legislature into turning down a deal, then things will really get interesting.  If there is no bailout at all, then the Cyprus banks will probably go under.  A few people may get to the bank in time and get their money out.  Most won’t.  So instead of 93%, most people will be staring at a zero balance in their bank account.  Perhaps if the banks went through a formal bankruptcy and sold off all of the assets, then depositors might get back a fraction of what they had, and this would likely be months later.

In other words, be careful what you ask for.  The Cyprus banks, especially the major ones, are insolvent.  They are even more insolvent after the proposal to take depositor money.  If they ever reopen, there will be a major run.  So while I like to see a good protest against the government, I’m not sure if the people are shooting themselves in the foot in this case.

I think we will ultimately see some kind of a rescue (bailout).  I don’t think the European Union will allow for the Cyprus banks to go down.  They don’t really care much about Cyprus, but they are afraid it will shake the confidence in the rest of Europe.  It could potentially start more bank runs in fragile places like Portugal, Spain, and Italy.

Governments and central banks around the world have made such a mess of banking that it is a tough topic for libertarians.  We have to remove the moral hazard, but it is hard to take a purist libertarian stance in the sense of trying to do something all at once.  The whole banking system is a mess and it is hard to just say “let them fail”.  If the average American started seeing bank failures where the FDIC did not step in, then we would see massive bank runs.  Many people would be wiped out.  We would see a drastic decline in the division of labor.  I think we need to get rid of the FDIC, but it is one of the few things where I think it might be more harmful than good if it was done overnight without some kind of a plan of transition.

This whole Cyprus situation just shows how fragile the whole banking system is.  It really does all rest on confidence.  I think that bailing out the banks is the one situation where the Fed would risk hyperinflation.  The Fed will eventually tell Congress that it will stop buying its debt.  Congress will have to figure out a way to balance the budget eventually.  The Fed will not turn its back on the major banks.