If Israel Needs a Bailout, the Man on the Street Will Pull for the Cyprus Model

Should each citizen pay an identical amount, or should the cost be allocated progressively like income tax?

The difference between saving and investing is ostensibly a simple lesson. You put your savings in the bank or under the mattress, basically without risk. Investment, meanwhile, presents both opportunity and risk, and in the end you either have more – perhaps a whole lot more – or less – perhaps nothing.

But this simply isn't so – an insight a small island near Israel has provided to the entire world: Cyprus. As we all know, the citizens of Cyprus, along with foreigners who deposited their money there, woke up two weeks ago to discover that a good part of the cash in their bank accounts – their savings – simply vanished and will never come back.

What exactly vanished? It's amazing that there's still no clear answer. Officially, deposits up to 100,000 euros are safe, but anything beyond that will be slashed by 30%, 60% or even 90% ­– depending on whom you ask. The only thing for sure is that right now the money can't be withdrawn.

Cyprus moved out of the limelight this week once its bailout package got under way, but no economist or banker will deny that, just as with Greece, the plan is just the first round.

Cyprus is now likely to sink deep into recession – analysts are talking about a 20% drop in output – and the consequence will be more bailouts that could entail another hit – a "haircut" – to the people's savings deposited in the banking system.

For Cypriots, the definitions of savings and investment got turned around: "Secure" savings are being cut by a double-digit percentage, while investments – real estate, cars, yachts, stocks and business ownership – have maintained their value. Even if the value of these investments erodes due to Cyprus' expected recession, the loss certainly won't be equivalent to a 50% reduction in money saved up.

Is any of this relevant to Israel? The saver abreast of the news surely has the impression that Cyprus is a special case – a marginal country where the banking sector grew to eight times the size of the economy thanks to money from the Russian mafia. So the saver concludes that the haircut on deposits there can't occur anywhere else; certainly not in a country in good economic shape – like Israel.

This isn't true either. World leaders make sure to put out the same spin – Cyprus is a unique case and in no way serves as a bailout model. But nobody believes it.

A Dutch slip of the tongue

The evidence is plentiful. First, the haircut on savings in Cyprus was recommended and approved by the heads of Europe.

Second, some politicians tripped up, like the Dutch finance minister, who declared that what's happening in Cyprus is a sign of things to come. This set off rumors that the Cypriot model will be applied elsewhere.

Third, analysts, bankers and their clients aren't buying the reassurances. UBS analysts wrote last week that events in Cyprus have left the saving public with much uncertainty, and that a bank bailout involving a partial default on bonds (after shareholders are wiped out) has become a likely scenario.

Actually, you don't need the opinions of experts or politicians, just logic. Over the past five years, there have been bank bailouts every few months costing tens or hundreds of billions of dollars. But these efforts haven't extricated the countries and economies from crisis. The slowdown continues, government debts and budget deficits keep swelling, and sooner or later more debt write-offs and rescue packages will be needed.

Who will foot the bill? In democratic countries the common taxpayer has been paying. The measures have maintained the bankers' and financiers' high income, while the printing of money in the United States and Europe has elevated asset prices.

We can assume that governments won't let things go this way next time around. We can assume that such a bailout will resemble the Cyprus formula: Accounts holding several hundred thousand shekels will be left alone, while larger accounts will get a haircut. And if the situation gets bad enough, haircuts on pension plans won't seem impossible either.

How big a haircut? Obviously there's no answer; it will depend on how bad the crisis is. Some observers say a 20% to 30% one-time tax on financial assets wouldn't be unreasonable.

The inflationary solution

Even if this scenario only happens in Cyprus, countries will need other ways of cutting into savings. The simplest way is through inflation. When a country has debts it can't repay, or needs to inject massive sums into the banking system, the easiest thing is to print tons of money – eroding the currency and shrinking the real value of government debt. Obviously this also has the effect of quickly debasing the value of people's savings.

Over several years, high inflation has the same effect as what happened to deposits in Cyprus – a double-digit haircut – except that the cost of the bailout again falls on the public while the upper percentiles with big investments find ways to maintain the value of their money.

The two alternatives raise a fundamental question: If a country enters a crisis, what's the best way to split the burden of a bailout? Should each citizen pay an identical amount or rate like value-added tax, or should the cost be allocated progressively like income tax so the well-heeled pay more?

Governments have chosen the first alternative, but Cyprus has put the second option on the table. Events in the coming months and years will influence the answer to this question. If money flees Cyprus and the island falls apart economically, politicians will learn that it's not worth it to fiddle with the public's savings. But if financial calm prevails and the country undergoes a surprisingly mild recession, the message will be that people can be parted from some of their savings and the sun will still rise.

Following the Cyprus episode, people around the world – including here in Israel – must realize that one day the government might come and take a big bite out of their savings. In planning for the long term, this should even be treated as a likely scenario, another thing to take into account when deciding how much to "save" and how much to "invest" – and how much to simply spend and consume.

Reuters