Cypriot precedents

The news that Cyprus, in return for an EU-led bailout, will impose a debt for equity swap 'haircut' on bank depositors, is  reverberating around the blogosphere and press. There is plenty of outrage on offer, though in fairness viable alternative proposals were thin on the ground.

This is the first time in this crisis that a large proportion of the cost falls on depositors, rather than tax-payers. That creates a precedent or two, though whether it is 'fairer' for a country's taxpayers to foot the whole bill, than for some to be borne by bank depositors, isn't completely obvious. 

The problem, as many people understand, is that Cyprus' banks invested too much  in Greek Government debt and lent too much money in Greece.   Since the value of all Greek  debt fell dramatically, the Cypriot banks lost sums that were too big to be covered through their own reserves, or those of their Government. 

Investment by Europe's banks in European government bonds was once thought to be a 'safe'  thing to do with savers' and shareholders' funds. But the term "European Government Bonds" was and still is misleading. Europe doesn't issue government debt. European Union member countries do. And they are not necessarily backed by the rest of the EU. Greece's debt certainly wasn't.

In the short term, I suspect that the most exaggerated  fears surrounding events in Cyprus will not materialise. There may be queues at cash machines this weekend but the Euro won't collapse and   we probably won't see all that much contagion across Europe's banking system. One of the reasons Europe is in recession is an excess of savings, and most of that excess will remain in the banking system.

Major change is however already under way as a result of this crisis. Cross-border investment and cross-border banking have been hit within Europe.  A French or German saver is already more likely now to keep his/her savings in a large domestic institution. And that institution is more likely to invest that money at home.  In financial terms, Europe is de-unifying from the bottom up.

There has always been a solution to this problem, and it has always seemed unpalatable to much of Europe - jointly issued and guaranteed Euro-bonds. If Europe wants to avoid gradual splintering of its financial system (which would leave a loose but inefficient  structure of regulation and bureaucracy surrounding one-size-fits-all currency) it is going to have to move closer to a Federal structure with a Federal central bank to control the creation of money and a Federal debt issuer to raise money for its members. Europhiles who don't want to go that far need to work out where they want Europe to go.