Bank run expert: Cyprus’ plan was ‘absurd’

March 20, 2013, 12:17 AM UTC

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.

Why do you think the plan was absurd?

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.

Won’t the bank holiday stop that?

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%.

But European regulators are trying to send the signal that the bailout they proposed for Cyprus was going to be a one-time thing?

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?

Well, because the real event that European regulators want to prevent, which appears not to be a one-off event, is periphery European nations living off the Euro and running up debt they can’t afford.

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.

Seems a little extreme. The last proposal was to tax small accounts just 3%.

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.