Does Cyprus Threaten European Economic Stability?

If it’s not one shock, it’s another. On Saturday, Cyprus revealed that it would raise 5.8 billion euros ($7.5 billion) in bailout funds, and it would likely do this by imposing a 6.75 percent charge on bank deposits. Market participants around the world are still digesting the implications.

The strategy is unconventional, to say the least. It’s important to note that unlike in most other European countries, local banks in Cyprus have a relatively small amount of outstanding bonds. This means that the government is unable to put the burden of the bailout on creditors, and is forced to finance the rescue through different means. European finance ministers concocted the tax as a mechanism to shift some of the burden away from themselves and onto the country seeking assistance.

Short of a consortium of eccentric but philanthropically-minded billionaires bailing out the island nation (crazier things have happened), Cyprus doesn’t have many options on the table. The country has an economy of about 18 billion euros ($23.5 billion), unemployment of about 14 percent, and in June of 2012, it became the fifth euro zone country to seek an international bailout. Its banks have already faced credit-rating agency downgrades.

But even with limited options on the table, many observers see the tax on deposits as a bad choice. Criticisms are varied, but broadly speaking, the tax is so large and so sudden that many fear it will create not just a financial shock, but a psychological shock. Evidence of this is abundantly apparent in the sea of red created by major index movement around the world on Monday…