Not to be alarmist, but it is with that thought that I view the problem in Cyprus.  Fair question — since our economy is 300 times larger than that of Cyprus, isn’t that like worrying about a fly on an elephant?

There is no one answer to that question.  One is that Cyprus banks own a large amount of Greek bonds.  If they are forced to dump those bonds, that will drive down the value, which drives up interest costs for its weak sister, Greece.  Another is that expulsion from the Euro is a real possibility, which has never been done before.  If that happens, there will be even greater chaos in Cyprus than there is already.  Unemployment and food prices will soar.  Gas could easily reach $20/gallon.  While it would probably be beneficial to the Cypriots in the long run, as it would become very cheap to visit or manufacture in that country, there will be much pain and social unrest in the short run.

More importantly, it is the first significant violation of a trust that has held for almost sixty years, i.e., bank deposits should be sacrosanct and protected.  The latest iteration of the Cypriot plan is that large depositors (over 100,000 euros or about $130,000) will lose 20% of the money held in the Bank of Cyprus and 4% in other banks.  Actually, the percentages don’t matter — the sacrosanct status of deposits is far more important.  (To twist the knife even more, the depositors will lose money but not the bank’s bondholders.)

The only way to prevent a devastating “run-on-the-bank” is to maintain faith in the safety of the deposits.  It was for that reason that Bernanke wisely removed the cap on FDIC coverage during our crisis in 2008/9.  Now, the question on the lips of every European (and Russian) is whether their deposits are safe anywhere.

There is incredible pressure on the Cypriot and EU leaders who are meeting today, and I wish them well.  However, I’m sure they are aware of the fact that a large amount of the confiscated bank deposits belong to the vicious Russian mafia.  It would be better for the mafia if the EU turns down the Cypriot offer to confiscate Russian deposits in Cypriot banks.  If they accept the Cypriot offer . . . well, thank God for Secret Service protection!

The similarity to the Archduke’s assasination is that a relatively minor event leads to huge consequences.  Only a few insiders really know who is holding the credit default swaps (CDSs) on Cypriot debt.  If Cyprus goes bankrupt, who has to pay?  Can they pay?  If your bank deposit is now in a bank that will have to pay but cannot, how would you know?  Where should you move your money to?  I expect the European branches of U.S. banks will receive a large amount of euro-dollar deposits, but it is possible U.S. banks have sold CDS coverage as well and have exposure.

While I do expect this crisis will not likely cause a derivatives blow-up, nobody ever expected Gavrilo Princip to kill Franz Ferdinand either.