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Cyprus's new finance minister ruled out a haircut on bank deposits to ease a financial bailout. "Really and categorically - and this doesn't only apply in the case of Cyprus but for the world over and the eurozone - there really couldn't be a more stupid idea."
--Reuters, March 1st, 2013

"The European Central Bank is pressing Cyprus to legislate a universal levy on bank deposits before international financial markets open on Monday...Cyprus gave way after the ECB threatened to push the island into a disorderly default by withdrawing liquidity support for Laiki, its second-largest bank, on Tuesday."
FT, March 17th, 2013

"The move to take a percentage of deposits, which could raise almost 6 billion euros, must be ratified by parliament, where no party has a majority. If it fails to do so, President Nicos Anastasiades has warned, Cyprus's two largest banks will collapse." -- Reuters, March 17th, 2013

Like many people, I enjoy monetary experiments. Usually these occur in Latin America, where unorthodox monetary ideas are being tried all the time. But we now have a new laboratory for monetary innovation: the eurozone. This weekend, Europe ordered Cyprus to haircut bank deposits, thus transforming them from money (M2) into a loss-absorbing instrument. That's innovative. This could be the "Next Big Thing" in monetary policy: the transformation of deposits into bank capital and/or government revenue. Cyprus is the ECB's new laboratory for monetary policy, a kind of EuroDisney. I trust that Mario Draghi is enjoying this experiment as much as the rest of us.

Now we have two Draghi Doctrines: (1) "Growth is irrelevant to the conduct of monetary policy"; and (2) "Bank deposits are risk assets". Mr. Draghi is always thinking up new ideas.

A bank deposit in euroland (or at least in southern euroland) is no longer money. Instead, it's a speculative zero-coupon instrument. (Note that deposits in branches of foreign or solvent domestic banks are also subject to this confiscation; bank solvency is irrelevant.) I can't over-emphasize how innovative this decision is.

Outside of euroland, bank deposits are considered money and, as such, as a contingent liability of the central bank. The ECB has just transformed what had been money into a risk asset. The Fed did this same thing in 1931, and it didn't work out well: the money supply was deposited into mattresses. Going forward, only the truly patriotic will keep their money on deposit in Club Med banks.

When depositors lose confidence, they redeem their deposits in cash or move them to banks beyond the reach of the government. Consequently, deposit withdrawals cause M2 to decline by the money multiplier, which causes deflation. This underlines the nonsense of the assertion that the eurozone is a "single monetary area". What's the outlook for Greek or Portuguese M2 growth in 2013, Mr. Draghi? The euro has now been balkanized into a set of defective national currencies.

In the three year saga of the European sovereign debt crisis, we have been told by the authorities that (1) default by a eurozone sovereign was "unthinkable", and (2) that a deposit haircut would be a "stupid idea". Well guess what: Greece has defaulted on its bonds, and Cyprus has haircut its deposits. What will be Europe's next experiment?

Source: Europe's Latest Monetary Experiment