FORTUNE -- You can thank Cyprus and Europe's leaders for making our $700 billion bank bailout look good.
The plan to impose a tax on bank deposits to help pay for the bailout of Cypriot banks was "absurd," says Philip Dybvig, one of the world's leading economic experts on banks and financial crisis. Back in 1983, Dybvig co-authored, along with University of Chicago economist Doug Diamond, a paper on why bank runs happen. It has since become one of the most influential pieces of research on the topic and on financial crisis in general, and is a regular staple of most economics curriculums.
Dybvig, who is now an economics professor at Washington University, says the plan to bailout Cyprus at the expense of local depositors would have done more harm than good and could have put more strain on the already troubled European banking sector.
The plan, which was proposed by European regulators and central bankers, was originally to levy a 6.75% tax on deposits of less than €100,000 and 9.9% on anything above €100,000 to help pay for a €10 billion bailout of the country's banking sector. At the last minute, an exemption for accounts that had less €20,000 was added, but that wasn't enough to save the plan. On Tuesday afternoon, the proposed deposit tax was rejected by the Cypriot lawmakers. And even though that has thrown the European bailout of Cyprus into doubt, Dybvig thinks the rejection of the deposit tax, if it sticks, will end up being a good thing.
It will do a lot of damage to the banking system both in Cyprus and Europe in general. The proposal also has to shake confidence of depositors in other countries, which is dangerous. The only reason people haven't run from their banks in other nations in Europe is that they think they have time. Eventually that runs out.
Bank holidays have a fun sounding name, but they are really quite harmful. When you tell people they can't have their money, it makes it very hard for an economy to return to normal. We tried bank holidays a few times in the Great Depression and it only made things worse. One reason to have deposit insurance is to prevent bank runs, but partial deposit insurance is ineffective if it does not cover 100%. You will run on your bank if you think you will lose 100% of your deposits, and you will also run if you think you will lose 10%.
If it's really a small, isolated, unique problem, a one-time thing, and won't happen again, why not do the just do the bailout and have the country pay for it over time? Why risk the potential damage to the rest of Europe's banking system?
Yes, I get the desire for a pound of flesh, but a tax on deposits, especially when you are saying this one-time thing won't stop countries and banks from running up debt. If the subtext is that this is the only time we are going to ask for deposits, what's going to happen the next time - we put that country's youth into slavery. It's not believable. That's the problem with selling one-offs.
A tax focused on bank accounts and not general wealth or income will have a strange incidence, and seems extremely unfair. And no matter how small, it can do a lot of damage to the banking system. Whenever you impose a tax on deposits you push people to find alternatives. And that means more money ends up in the shadow banking system, which is much harder to regulate. That's what in part led to the U.S. financial crisis.
Critics of our analysis say Uncle Sam should have let the free markets take care of business. They tried. And they failed.
FORTUNE -- My last column, looking at five myths and misconceptions that have emerged since the financial crisis first surfaced five years ago, clearly hit a nerve. It elicited more than 500 online comments, an unusually large response. Most commenters were critical of what I wrote, which is par MOREAllan Sloan, senior editor-at-large - Jul 5, 2012 5:00 AM ET
Here's one instance where you should give the Treasury an "F" for effort.
Correction: 5/24 12:57
FORTUNE -- A few weeks ago the Treasury Department put out its latest report of what the government's rescue efforts in the wake of the financial crisis cost taxpayers. The conclusion: Nada. In fact, the Treasury says that if you take a broad view of all the bailout programs, taxpayers actually are looking at a $9 MOREStephen Gandel, senior editor - May 21, 2012 1:59 PM ET
Clarification: 3/8 8:40 AM.
The Treasury Department is selling $6 billion worth of its AIG stock at a profit. But it's still not clear taxpayers will come out ahead on the insurer's bailout.
FORTUNE -- The good news: The government is about to get an another $14.5 billion of the money it poured into AIG (AIG) at the height of the financial crisis. The bad news: Uncle Sam is still owed $36 MOREStephen Gandel, senior editor - Mar 7, 2012 6:19 PM ET
A mass mortgage refi solution is getting support from both sides of the political aisle. And it wouldn't cost taxpayers a dime.
FORTUNE -- Main Street taxpayers have bailed out Wall Street. Now it's time for Wall Street to return the favor by footing the bill to help millions of honorable Main Street borrowers pay lower interest rates on their mortgages, something that should have happened years ago. Wall Street giving MOREAllan Sloan, senior editor-at-large - Jan 18, 2012 5:00 AM ET
Why Greece's bailout may not prevent a Continental credit crisis and another global economic slowdown.
The Greek Parliament approved a tough austerity plan so that the country could get money from the European Union and the International Monetary Fund, including the rest of the bailout hammered out last year and a second aid package. Europe's officials have now spent nearly $270 billion to keep Greece going, signaling that they will spend whatever it MOREKatie Benner - Jun 30, 2011 1:21 PM ET
Who is most eager to put the AIG bailout in the rearview mirror?
The government would certainly like to sell off its holdings in the giant insurer sooner rather than later. Witness its decision to sell a big chunk of AIG (AIG) shares this spring even with the stock down sharply from its level at the end of 2010.
But AIG chief Bob Benmosche makes clear in the video below that he MOREColin Barr - Jun 22, 2011 4:21 PM ET
Have Europe's leaders kicked the Greek can as far as it will go?
Unnervingly, it is starting to look like the answer may be yes. Policymakers this week failed yet again to take decisive action on Greece's debt crisis, rattling markets and prompting billionaire George Soros to brand officials' failure to restructure Greek debt a "mistake."
The central problem -- beyond Greece's running out of money again -- is a standoff between bailout-shy politicians and MOREColin Barr - Jun 15, 2011 10:59 AM ET
The banks spend a lot of time carping about economic uncertainty. But they have no one but themselves to blame for the latest pratfall at Ally Financial.
Ally, the car lender formerly known as GMAC that was rescued after a disastrous spin down subprime lending lane, had been hoping to do an initial public offering this month but is now more likely looking at the fall, the Financial Times reported.
The firm has MOREColin Barr - Jun 10, 2011 11:49 AM ET
Four more years! Four more years!
That's what Citigroup's (C) board was inexplicably chanting this week as it signed up for another term under Vikram Pandit, the CEO whose signal accomplishments include repaying a giant government bailout and executing a reverse stock split that rescued Citi from penny stock purgatory.
That's not much of a record, but Citi is grateful anyway. It signed Pandit to a deal that will hand him more than $20 MOREColin Barr - May 19, 2011 10:19 AM ET
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