Daniel J. Mitchell
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It doesn’t create a lot of confidence in Europe that tiny little Cyprus, with a GDP less than Vermont, is now causing immense turmoil.

Though to be more accurate, events in Cyprus aren’t causing turmoil as much as they’re causing people to examine both government finances and bank soundness in other nations. And that’s causing anxiety because folks have taken their heads out of the sand and looked at the reality of poor balance sheets.

Looking closer at the specific mess in Cyprus, an insolvent financial sector is the cause of the current crisis, though the problem is exacerbated by the fact that the government has dramatically increased the burden of government spending in recent years and therefore isn’t in a position to finance a bailout.

But that then raises the question of why Cyprus is bailing out its banks? Why not just let the banks fail?

Well, here’s where things get messy, particularly since we don’t have a lot of details. There are basically three options for dealing with financial sector insolvency.

  1. In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.
  2. In a system with government-imposed deposit insurance, taxpayers (or bank consumers via insurance premiums) are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.
  3. And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

As far as I can determine, Cyprus wants to pick the third option, sort of akin to the corrupt TARP regime in the United States. But that approach can only work if the government has the ability to come up with the cash when banks go under.

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Daniel J. Mitchell

Daniel J. Mitchell is a top expert on tax reform and supply-side tax policy at the Cato Institute.