The First Crack in the Dam (of Confidence)

The bailout drama in Cyprus had created an atmosphere of uneasiness and suspense in Europe for the last two weeks. The significance of the events has been dismissed by most people, even economists and political pundits, all pointing out the fact that because Cyprus makes up just 0.2% of the European Union's GDP, that the damage to the larger Eurozone would be minimal. However, the economy is global with a lot of working parts integrated together (and has been that way since the 1400s, but society is more connected now than back then), meaning that when one part sustains damage or goes down, a chain reaction can happen.

As will be demonstrated here, the drama in Cyprus is much more serious than many would think. What happens in Cyprus affects the European Union, and eventually, the entire Western World. The next phase of the "Crisis of the Western World" is approaching. The drama in Cyprus started when the two largest Cypriot banks became insolvent and needed a 10 billion euro bailout.

The stage for the Cypriot financial crisis was set with excessive exposure to the Greek debt crisis (through investment in Greek treasury bonds, which have been considered junk bonds) and the downgrading of the Cyprus economy to junk status. Moody's had downgraded the credit rating of Cyprus to junk status on March 2012, citing the need for the Cyprus government to inject more capital into the banks. In June 2012, Fitch downgraded Cyprus bonds to BB+, no longer qualifying as investment grade as far as acceptance as collateral by the ECB is concerned. A short time later, Cyprus requested a bailout from the European Union's Eurpean Financial Stability Facility or European Stability Mechanism.

The drama started on March 16, 2013 when the European Union agreed to a 10 billion euro deal with Cyprus. In the first action of its kind, the part of the terms of the bailout is a so-called "wealth tax" that takes up to 10% of deposits for all domestic bank accounts.

1 -- News of the "wealth tax" sparked a mini-bank run in which people attempted to pull their money out of the banks as fast as they can. Many local ATMs ran out of cash in a matter of hours. With the sudden scarcity of cash in Cyprus due to the bank closures, many businesses have stopped accepting credit card payments.

2 -- The Cypriot government rejected the terms of the bailout on March 19, 2013. In the aftermath of the failed vote, The Cypriot government declared a bank holiday that would eventually last over a week. When the banks re-opened on March 28, 2013, capital controls were were already in place setting limits on how much money can be withdrawn along with the deployment of police in the streets amid the fears of a bank run.

3 -- When the bank holiday ended in Cyprus, the damage was already done. Many businesses and aging retirees saw their savings wiped out by the "wealth tax", losing as much as 80% of their life savings overnight.

Many politicians, economists, financial analysts, and news pundits have shrugged off the drama in Cyprus as "not a big deal".  The significance of the events in Cyprus is not recognized by most people. Confidence is an ironic thing --- it takes decades to build, but it takes only a few days to tear it down. Confidence is a very important part of keeping the banks fully functional. With the "wealth tax" genie now out of the bottle, the first crack in the dam (of confidence) has formed. The "wealth tax" has already caused some real damage to people in Cyprus and it has also caused many people in southern Europe to question whether their savings accounts and checking accounts are truly safe.

When people no longer feel that the money they have in the banks is safe, they become more likely to pull it all out. There is a reason why people stuffed their money under their matress in the 1930s during and shortly after the Great Depression (hint -- over 9000 banks imploded from 1929 to 1932).
There are very strong indications that the people at the top of the pyramid are oblivious to the cracks in the dam of confidence (see above). When a dam develops a crack, it becomes weakened and the cracks get larger over time. Eventually, the entire dam gives way and bursts.

There are already indications of more cracks in the dam of confidence that could form in the future:

1 -- Banks in Slovenia are in need of billions of euros of fresh capital and are struggling with bad loans that equal a fifth of the country's economic output.

2 -- There is already discussion of depositor haircut provisions for systemically important banks in Canada as part of the 2013 budget.

The first crack in the dam of confidence has formed. Over time, the cracks are expected to get larger, weakening the dam over time. When the dam bursting event takes place, the result is a full scale bank run throughout the Western World. The dam bursting event is most likely to take place in 2015 or 2016 and will start in Europe before spilling into the United States and Canada. The "tax wealth" genie is out of the bottle and it is going to be very difficult for people in high places to put it back in.