There are a lot of problems with Cyprus. Actually, there are problems everywhere, but I am picking on Cyprus right now because of the government's confiscation of bank deposits. While this is a major blow to the country and to anyone who has high deposits in a Cyprus bank, there is an even bigger problem. The bigger problem is that this so-called solution of confiscation will not fix any of the problems in the long term.
Right now, it is hard to say that banks in Cyprus are open. They are open under tight rules. There are cash withdrawal limits and severe capital controls.
How do people pay their mortgages? How do they pay their other bills? What do the banks and businesses do that are owed money and aren't getting paid? It is one big wave of bad effects.
Travis Holte posted this on the LRC blog. I have no reason to doubt its validity. Even if it weren't real, this is the reality of the situation. It shows the bank account statement for a business owner in Cyprus. The total balance is almost $850,000. The blocked funds are over $720,000. The owner says, "The business is definitely ruined, all Cypriot workers to be fired."
Money is vital in an economy. It is at least half of most trades and transactions. You buy something and pay money. You sell something and you receive money. You work (sell your labor) and you receive money. If you don't have a functioning medium of exchange, then business will slow down or come to a virtual halt. There will be a severe contraction in the division of labor.
This is the reality for Cyprus right now. It cannot go on with severe capital controls and a completely untrustworthy banking system. Something has to change quickly or the standard of living there is going to plummet. It is going to go down regardless. But if the government would allow a true correction to happen without bailouts and more government involvement, then there would at least be some hope for a decent recovery in the near future.
Most major countries in the developed world are facing something similar to Cyprus. It is not exactly the same, as some countries have their own central bank and fiat currency, which allows them to conceal the confiscations easier. But there is way too much government all over the globe. Almost all government spending is malinvestment. Governments misallocate resources and don't have the free market pricing mechanisms to correct for it. This wastes resources and makes our standard of living lower than it should be.
I don't think there was much choice in bank depositors taking a haircut. It should have been handled as a bankruptcy. This is the trouble when governments insure banks. A bank that engaged in heavy fractional reserve banking or a bank that invested in risky assets (like Greek bonds) would likely never receive insurance in a voluntary free market.
If we had a free market system in banking, then customers would be far more careful with their deposits. Banks would likely be far more conservative and would not engage in this severe form of fractional reserve banking, if at all. I can envision competing banks. One bank might have fractional reserve banking. You could be a customer of the bank and getting higher interest rates, knowing that your money was more at risk. Then you could have another competing bank where you pay a small fee and the bank does not engage in any fractional reserve lending on checking deposits. Conservative savers could use this bank to keep their money safe and sound.
We have nothing resembling a free market in banking now, whether in the U.S., Cyprus, or any other developed country. The government makes these ridiculous promises and then the banks take these big risks, knowing they will be bailed out if they turn out to be wrong. Until this is fixed, we will continue to see problems around the world. We need a free market in money and banking.