Of all the many steps that the euro area has taken to contain its debt crisis, the decision to force ordinary savers in Cyprus to contribute to their country’s bailout is the worst.

We’ll have to wait and see whether this breach of the principle of deposit insurance triggers a run on the banks of other endangered economies, such as Greece and Spain. Yet even if no contagion results, Europe’s governments have knocked a supporting wall from beneath their financial system. As today’s flight to safety in markets shows, the euro-area crisis is center stage once more.

Technically, the rescue package for Cyprus doesn’t violate the euro area’s guarantee that all deposits up to 100,000 ($130,000) are insured. That’s because the proposal for the Cypriot government to take 6.75 percent of all bank deposits less than 100,000 euros, and 9.9 percent above that amount, is defined as a tax. Depositors, however, will see this for what it is: a raid on their savings.

Such an attack on ordinary depositors is unjust, politically obtuse and economically destructive all at the same time. It has rightly fueled popular outrage. Savers in Cyprus are being asked to give up 5.8 billion euros so that international creditors will provide the remaining 10 billion euros required for a bailout. Thus will bondholders in London, Frankfurt and New York be spared a haircut.

Tough Choice

The euro area does face a tough choice with Cyprus. The country, which accounts for less than 0.2 percent of the currency zone’s economy, has built up an absurdly oversized banking sector with assets eight times larger than gross domestic product. Now those banks are in trouble, and Cyprus isn’t large enough to rescue them on its own. Think Iceland inside the euro area.

A Greek-style bailout -- which would squeeze taxpayers, pensioners and the public sector until the country’s debts were under control -- is easily affordable for the rest of the euro area, at 17 billion euros. But it would be no more equitable that an attack on savers.

That’s because Cypriot bank deposits include huge amounts of Russian money, much of which is escaping taxation and getting laundered via Cyprus. Germany and other creditor euro nations are therefore reluctant to foot the whole bill for a bailout. A bail-in of the banks’ bondholders can’t make up the difference, because there aren’t enough of them.

It may be that in the case of Cyprus, the best option is to require high-value depositors to share the costs of a bailout, not least because doing so would enable the euro area to make a more convincing argument as to why this demand on depositors won’t be repeated elsewhere. Such a penalty could also be designed to spare longer-term savers with large deposits. For those depositors who are tax evaders and money launderers, a loss of even 30 percent of their assets in Cypriot accounts would be just a cost of doing business.

EU finance ministers have made it clear they are ready to consider any design of the tax Cyprus proposes, as long as it raises the same total sum. So there is no reason for the Cypriot government to include savers with less than 100,000 euros in their accounts. No reason, that is, except the fear of alienating foreign depositors and destroying Cyprus’ offshore banking business overnight.

Yet this is exactly what needs to happen. When Iceland’s banking bubble burst, the government quickly realized that the country’s economy could no longer be so dependent on finance and allowed the banks to implode. The euro-area finance ministers appear to have understood this, too -- they said in their joint statement that their goal was for the Cypriot banking system to shrink to the average euro-area size by 2018.

Damaging Signal

What’s impossible to understand is how these finance ministers agreed to let Cyprus attack insured depositors, an act of recklessness sure to have implications for the rest of the currency zone. Even if, as seems likely, the Cypriot deal is now changed to redistribute the pain from small to large account holders, the finance ministers have sent a damaging signal: Europe’s guarantee that its governments will stand behind deposits of less than 100,000 euros is no longer certain.

The euro area needs to recognize its mistake quickly and control the damage. It should demand that Cyprus levy its tax only on deposits above the insured level -- and impose losses on the banks’ bondholders as well, even if the sum raised is only symbolic. The Cypriot government will then have to increase the levy on savings exceeding 100,000 euros to make up the difference, taking the risk that Russian and other foreign investors withdraw their funds. If that ends the Cypriot offshore banking model, all the better.

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