How do you know when you are living in a failed nation-state? When people start lining up to get their own money out of banks.
Ok, so that's not entirely true: horribly run banks can also cause people to do a mass withdrawal of their funds. However, it's usually a pretty good sign that everything has gone to shit when the dreaded death knell of capitalism has rung: a run on the bank.
Anyone who's watched It's A Wonderful Life knows what happens. In case you never took Banking 101, it may be useful to know why a bank run is such a bad, bad thing. People put money in banks. The banks, in turn, lend out that money to other people who need it (presumably for cars, houses, small businesses, etc.) So when you deposit your money in a bank, it's gone. (Banks make money, of course, by charging more for loans than they do in savings accounts, which given the interest rates these days, tells you a lot.) They are required by law to have a certain amount of cash on hand, but beyond that the rest can be lent out. If a bank finds itself out of cash, either because they had more withdrawals than expected or not enough loans were repaid back, they can get more on loan from the Federal Reserve. (The amount required to have on hand, and the rate at with the Fed loans banks money, are two of the big tools the Fed uses to manipulate the economy.) It's a pretty elaborate system with a ton of checks and balances, but it's still not difficult to envision the entire thing as a big house of cards.* (I'm describing consumer banking, here; investment banking is something entirely different, as Glass-Steagall could have told you twenty years ago.)
So people place their money in the bank with the implicit impression that, while their money is going straight back out the door, it's still going to be there when they need it. Banks, in turn, do everything possible to earn the trust of consumers; that is why, back in the day, banks went out of their way to build huge, grandiose marble facades. By investing so heavily in their physical properties, it displayed that they had the money to back up your accounts. (Now that you can bank at a drive-through window or a strip mall or in a trailer hitched up to a donkey, that sort of thing isn't quite so, um, common.) When there is a threat to this trust--say, when Uncle Billy lets Mr. Potter take the deposits on the day the bank examiner comes or (more realistically) a bank makes enough bad loans that will not get paid back (and therefore nothing to back up the deposits, and no collateral for the Fed to use to replenish the money)--people make a run on the bank. As in depositors literally run to the bank so they can get their money out before anyone else does and the bank simply runs out of cash. Since so many banks are interconnected--for good or ill--a failed bank affects other banks as well.
Anyway, the long post above is why bank runs are always a bad idea. The house of cards depends on trust. (For those that don't care for this fragile arrangement, note that nearly 99% of the time the system works exceedingly well.) We know our money is flitting out the door, but we also know that the bank has our back, so to speak. When one single ounce of trust is lost, people get jittery; and when one person gets jittery, they all do. It feeds on itself until the bank is ruined.
So when you hear about what happened in Cyprus, it is usually an incredibly, despairingly bad sign. In this case, though, it's the government that is causing the issue. As part of a bailout plan for the small island nation, the government agreed to the EU's plan, which would levy a one-time tax on all deposits. When Cypriots woke up Monday morning, whatever money they had in the bank was between 3-10% less, the money taxed away by the government. Someone who shoved their money under a mattress--they were perfectly fine. People who spent every last penny they had and had no savings--they didn't get dinged. Only people who trusted that their money would stay in the bank were hit with the penalty.
Immediately, there were calls to reverse it, but guess what? The trust is gone. If the government was willing to raid savings once, who says they won't do it again? No one in Cyprus--and, alarmingly, the rest of the EU--now views their deposits as safe. This is a very, very bad sign for a healthy economy. It was incredibly foolish for the Cyprus government to agree to it, and equally foolish for the EU to even offer it--because now, other struggling nations now know that consumer deposits are on the table to be negotiated away. Even if the plan is shelved and never brought up again, it's out there, and the idea got far enough for some bureaucrats to offer it and another set of bureaucrats to accept it. The losers, of course, are consumers, but even more so the banks, who, while they certainly had some economic trouble and did legitimately need a bailout, had little to do with agreeing to the plan and now their one main tool--trust--has been taken away from them.
Of course, politics entered this as well; Cyrpus is a known tax haven for Russian oligarchs, so there is a certain element that this was directed at them. A less clumsy plan surely would have been a better idea.
What does this mean for the future of EU? I don't know, but if we are fishing for silver linings, I can say things can only get better.
The Pledge: That's a lie. There are a thousand worse things the EU can do for their economy, and I guarantee they're going to try them all. This is the sort of thing revolutions were invented for.
*To any proper economists, I apologize for the simplicity of this explanation; to any Ron Paul supporters, I get it, but the house of cards that the Fed supports is not nearly as big as the house of cards in a banking system without the Fed. I'm sympathetic to many complaints about the Federal Reserve, but I take a "I'd rather have smaller problems than big ones" when it comes to something as fragile as the banking system. I may change my mind some day but it's not on my list of concerns at the moment.