The Cyprus banking crisis is a useful teachable moment about banking and taxation — so I guess I’m not surprised that this opportunity is being entirely missed by the media, most of whom probably don’t know what’s actually going on, either. Both the left and the right are incensed at the Cypriot government’s proposed solution: a 6.7-9.9% tax on savings account balances will raise funds which will then be used to bail out the banks. That didn’t go over well. The result was that the government backed away and is now frantically considering other options. It needs to raise a few billion euros to qualify for a bailout loan from the rest of the European Union. It doesn’t have the money.
But what intrigues me is the controversy over the bank account tax. News of this tax flashed around the world. Various left-wing outlets are describing this as a grand theft organized by European technocrats. The right is playing populist by denouncing the seizure of hardworking Cypriots’ money to perpetuate bad government policy (although credible rumour has it that the largest accountholders in Cyprus are actually Russian oligarchs).
The trouble is, I don’t think a lot of people really understand how banking works. Because if they did, I don’t think they’d find the savings tax all that upsetting. If you’re going to have bank bailouts, then savings account taxes are probably one of the best ways of financing them. A better way would probably be to hand over ownership of the bank to the people with savings accounts, which I’ll get to later. But the important thing is that we discuss these things with the proper background knowledge of what’s going on. The media evidently doesn’t see its role as providing this sort of education to the masses, and neither, evidently, is the school system doing so, which leaves anyone who has never taken a macroeconomics course a few steps behind, understanding-wise. Ain’t modern democracy grand?
The most important reality that I think the vast majority of people don’t understand is that despite what your monthly statement may say, you don’t actually have (almost) any money in the bank. Bank accounts are not like safety deposit boxes. A savings account is actually a loan. You loan the bank whatever you “deposit.” In exchange, the bank promises to pay you a trivially small amount of interest, plus to pay up on the loan whenever you demand it, in the form of a “withdrawal.” Then, the bank takes your money and loans in to other customers.
This system, called fractional reserve banking, works because the bank knows that its creditors — meaning, you and me — will only demand a small fraction of their collective deposits on any given day. So, it only needs to hold back a few percent of that pool to give out on an as-needed basis. The rest of that money, it can do with as it pleases. It can take it and invest in Greek government bonds, for instance, like Cyprus did. Whoops. Or it can loan it out to other bank clients as a mortgage. Or whatever. As long as the investments don’t go up in smoke and as long as the account-holders don’t all show up on the same day demanding to withdraw all their money, the system can appear entirely normal.
Governments try to limit the damage through vehicles like deposit insurance, although the net effect is that in exchange for preventing all small-scale crises and bank runs, you create an appearance of total normalcy until a really big crisis comes along. In Canada, for instance, we feel that our accounts are “safe” because they’re insured by the Canada Deposit Insurance Corporation. CDIC currently guarantees that the first $100,000 in your account is safe, no matter what. But that’s a total of about $650 billion right now. CDIC doesn’t have $650 billion to pay out. Instead, it has around $2 billion.
What this means is that, despite what everyone (including the banks) tell you to think, you really shouldn’t think of your savings account as a pile of money waiting for you to use it. It’s a loan to the bank, plain and simple. That’s why you earn interest on it every month. The banks don’t pay us very much interest, because of supply and demand: they don’t have to. We loan them money anyway, habitually, because we’ve all been raised to think that it’s entirely normal to loan the bank money every time you have more cash on hand than you absolutely need for the day’s expenses, and because banks have such a good track record for paying off loans on demand that it doesn’t really feel like there’s any risk involved.
But there is risk involved. Canada is only one mass trip to the bank away from being the next Cyprus (except it can’t be: more on this in a moment.) Every so often, a combination of bad government policy and bad private bank investment activities — it doesn’t actually take both of these, but they usually go together — combine to cause multiple large banks to be unable to meet their financial obligations. At that point, the governments bail out the banks, to the tune of trillions of dollars if necessary. The right screams that this is distorting the market and the left screams that the banks should just be nationalized. The “centre” takes the worst of both worlds by offering exorbitant taxpayer-financed bailout packages to private corporations.
Which brings us to Cyprus and its controversial bank account tax. Never mind the fact that without a bailout (or a nationalization) in some form, the people with these savings accounts will be totally broke anyways. If the money isn’t raised somehow, the banks will collapse. So they’re protesting that writing off 7-10% of their savings as a tax is an unfair way to save the other 90% of their savings.
But notice that everyone is still behaving as if “their savings” are involved. As I’ve explained here, “their savings” are already gone. They’re not customers waiting for service, they’re creditors with amounts owing that can’t be paid up right now. If you’re one of the unlucky millions who has just found out how the banking system really works, well, tough luck. If you’re upset at the prospect of the government taxing one-tenth of your savings, think about the prospect of losing 100% of your savings.
But there’s almost no question, anyways, that there will be some sort of bailout. The question is, where will the money come from? This is where the Cyprus case could give us some real lessons, if we want to learn them.
Traditionally, the way that governments keep the banking system solvent is by creating more money. Outside of a major crisis, they do this a little bit at a time. The result is that there’s more money to go around, but each dollar is worth a little bit less in terms of what it can get for you in the market. It’s a steady trickle of devaluation so gradual you barely even notice. In Canada, the official goal for the inflation rate is 2% per year. Right now, it’s lower than that. In the past it’s been much higher; during the 1970s, it rose above 10% for a number of years.
Notice, though, that inflation has exactly the same effect on bank account balances as the proposed Cyprus bank tax would. 5% inflation is equal to a 5% tax, except that instead of actually taking money away, it’s just making the existing money worth less. So the inflation associated with printing money, or inflation for any other reason for that matter, is the same as a savings tax. The difference is, inflation affects all money. The Cypriot bank account tax would only affect people who deposited their savings in bank accounts. In practice that’s pretty much everyone, so the net effect would be similar, but as a means of bailing out failed banks, a bank account tax is actually fairer than inflation because you would only suffer in the taxation case to the extent that you’d loaned money to the banks in question.
All that said, even if a savings account tax is the “fairer” option, it’s also a completely unmanageable one. As Cyprus quickly learned, if you tell everyone that 10% of their savings accounts will be confiscated on, say, next Wednesday, then everyone will try to make sure they don’t have any money left in their savings accounts on that particular day. But the banks don’t have the money. So they can’t process all the withdrawals. And you end up with a bank run anyways. It would be hard to implement a savings tax specifically on bank account balances without creating some sort of mass financial panic, and even harder to do it as a one-time-only event, which is what Cyprus has tried to do.
There is another option which seems reasonable to me (and I would be interested to see it discussed by anyone who actually knows anything about business): allow a bank, perhaps upon authorization from the relevant government department, to convert bank account balances into equity shares in the bank. Capped at, say, 10% of the total balance. As far as I can see, this would make it the same loss to account-holders as Cyprus’s proposed bank account tax, except that it would leave the account-holders with something tangible for their loss: an equivalent amount of ownership in the bank.
Under the circumstances, of course, that may not sound terribly attractive to you: who wants to own shares in a Cypriot bank which has already been downgraded to junk status by the bond rating agencies? As unattractive as it might be, I propose this option because (a) the people are probably going to lose at least this much money one way or another anyways, whether it’s to inflation, bankruptcy, or a savings tax; and (b) this is how things normally work when a company goes bankrupt. The people who are owed money come first in line before the people who own stock, and one way of making up the shortfall between what they are owed and what the company actually can give them is made up through ownership.
The result is that the current owners’ shares are worth less, the creditors take on ownership in the ailing company, and hopefully a new management is able to put things back on a sound financial footing. It’s not perfect, but it’s better than nothing, which is what the Cypriots are being offered in the case of a tax. It would be different if the tax was for actual government revenue. In this case my understanding is that the tax is simply being imposed to raise funds for the banking sector, so it’s basically equivalent to just chopping 10% off of everyone’s account balance.Tweet