My Foolish colleague Morgan Housel's recent analysis compared the proposed Cypriot banking bailout with inflation in making the case that it might not be as ugly as it seems at first blush. While Morgan is absolutely correct that theft by inflation hurts people over time just as assuredly as this bailout will immediately sting depositors, there are a few reasons why this proposed bailout is much worse than inflation.
Indeed, as initially structured, the bailout may very well further destabilize the Cypriot banking infrastructure while simultaneously throwing a monkey wrench into the economy. Inflation, while a sneaky eroder of wealth over time, does neither of those. Harsh medicine may very well be called for, but if so, it needs to be taken out of the bank investors, rather than the depositors, in order to protect the critical foundation of any deposit-based banking system -- the reliability of the deposits themselves.
Outright theft from working stiffs
For one key difference, put yourself in the position of an ordinary Cypriot that works paycheck to paycheck. Your paycheck gets deposited into your bank account, you use the money to pay your bills, and by the time your next paycheck comes around, your account is mostly empty.
All of the sudden, you wake up one morning and find out that you've lost nearly 7% of your account value to this fee. The key problem: Your bills didn't go away. Your mortgage still needs to be paid, and you still need to eat and pay the electric bill. Only with an instant 7% haircut to your account, the money ain't there to pay the bills today. And when you can't pay your bills, the people you owe may not be able to pay their bills, either...
Contrast that with inflation, even a 7% inflation rate. For one thing, one of your biggest expenses -- housing -- likely has fixed costs over locked time periods. That's otherwise known as a rent contract, a fixed-rate mortgage, or even an adjustable-rate mortgage with annual adjustment windows. Sure, rent or an adjustable rate can go up, but only once per contract cycle, and you get an advanced warning that it's coming. That advanced warning gives you time to prepare or adjust.
Additionally, while inflation is usually expressed as a single number, the reality is that not all prices go up uniformly, and consumers often have the ability to substitute other goods to keep their costs down. When your money just disappears because of legislative theft, you don't have much choice to soften the blow.
Destructive to the banking system
Additionally, assuming this bailout plan goes through, it raises a key question: Who in their right mind would ever put another dime in a Cypriot bank account again? Bank depositors' money has been sacrosanct for a reason: With no deposits, banks have nothing to lend out. That's why programs like the U.S. FDIC are so focused on protecting depositors' cash. If depositors pull their cash and cause a run, not only do the banks face an uncomfortable (and potentially devastating) run on the bank, they lose the reserves they need to hold in order to make loans.
The fact is, bank deposits are sacrosanct because runs on the bank destroy banks. If the lines and emptied-out Cypriot ATMs thanks to this pending seizure are any clue, the very act of proposing this theft was enough to launch a bank run over the weekend. Once the "holiday" ends, if this theft of cash is allowed to happen, watch a big chunk of whatever capital is left flee Cyprus as fast as clicks on the Internet will let it.
In contrast, inflation doesn't cause capital flight -- instead, it simply raises the cost of capital. Any rational lender asks for a real return on his or her money, pricing in both expected inflation and an additional time premium for longer-term loans. That time premium is there, in part, to cover the risk of even higher future inflation as the lender's capital is tied up.
Here in the states, for instance, the only reason interest rates are as abysmally low as they are is because the Federal Reserve is actively buying Treasury debt. The Federal Reserve's stated goal with that plan is to get ordinary investors to stop buying Treasuries (because the rates are uneconomically low thanks to the intervention) and start buying riskier assets instead. Absent that program, interest rates would be higher to more adequately compensate lenders for the risks of inflation.
Inflation is bad -- but outright theft is worse
Given a forced choice between inflation and theft, any rational person -- other than the those who stand to benefit from the theft -- would take inflation over outright theft. You can plan around, invest around, adjust your buying habits, or otherwise protect yourself from inflation. When your money is stolen with no notice, you have no way to effectively adapt.