Cyprus' Unprecedented Bailout: More Common Than You Think

The tiny nation of Cyprus was bailed out by its eurozone partners and the IMF this weekend. That much is barely news. The bailout of a country with a broken banking system is now known as a slow Sunday.

But there was something different about Cyprus' bailout that sent shivers through the global banking system. Deposit holders in Cyprus banks are being forced to pay for part of the deal. The original deal, which looks like it's now being revised as I write this, says those with 100,000 euros or more in Cyprus banks will have 9.9% of their deposits levied -- or taxed, or confiscated, or whatever you want to call it. Those with less than 100,000 euros will take a 6.75% haircut.

This is rare, if not unprecedented, in modern bank bailouts. Deposit holders have long been considered sacrosanct. In the U.S., we have the FDIC. A bank's shareholders can lose everything when it screws up. Bondholders can take a hit, too. But deposit holders, particularly small mom-and-pops, are typically untouchable. "The FDIC has a long history of stability and safety," says former chairwoman Sheila Bair. "No one has ever lost a penny of insured deposits." Europe can't say the same.

But there's another side to this story.

If Cyprus had its own currency, it would be dealing with its economic problems by printing money. That would eventually cause inflation. How much? I don't know, let's say 6.75%. In that case, those with cash deposits in Cypriot banks would lose 6.75% of their money in real terms -- the same amount being directly confiscated on most deposits through the IMF bailout.

Think of it that way, and Cyprus's bailout fee is only unprecedented in a semantic way. When a government directly takes 6.75% of deposits, people freak out. When the government takes money indirectly through 6.75% inflation, few are concerned.

There are two takeaways from this.

The obvious one is that Cypriots are getting a raw deal only if you consider the bailout fee in isolation. Compared with what would have likely occurred without a bailout, it isn't bad at all. Most estimates I've seen of what would happen if Cyprus were forced to leave the euro and return to its old currency predict a devaluation of 40% to 60%. The country was in a terrible position with no easy solutions. It took the least bad option.

The other takeaway is that when it comes to cash, the difference between inflation and a direct levy is minimal. Most don't think of inflation as a fee because they don't see money being directly removed from their bank accounts. But the effect on wealth is the same in the end. Sheila Bair is right that no one has ever directly lost a penny on FDIC-insured deposits. But an untold amount of deposit wealth has been lost to inflation.

I'm neither a conspiracy theorist nor a goldbug, and this is not an anti-Fed rant. There will always be inflation, and dealing with it is more useful than grumbling about it. There are plenty of options to invest money at rates of return above inflation. Charlie Munger once said: "I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not."

The problem is that so many investors have willingly made themselves subject to inflation's mercy, plowing into cash and bonds that yield less than inflation. They are subjecting themselves to their own mini-Cyprus bailout fee year after year.

What's unfortunate is that they may not even know it. Cypriots are well aware of their fee. They see the headlines. They'll see the withdrawals. Money here today will be gone tomorrow. Other people around the world who invest in the comfort of FDIC-insured cash and bonds yielding nothing, I'm afraid, are much less aware.

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Morgan Housel doesn't own shares in any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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