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Cyprus bailout backlash poses little wider risk - for now 

The explosive backlash to the latest European bailout – this one for tiny Cyprus – will have limited impact on U.S. consumers, businesses and investors.

But the aftershocks are a potent reminder that the ongoing European crisis – relatively dormant in recent months – is far from over.

The latest $13 billion chapter in Europe’s efforts to reverse the economic free fall of its most heavily indebted members came with a nasty, surprise kicker.

In the past, European officials have asked investors holding debt issued by government bailout beneficiaries to take a “haircut” - and bear some of the bailout pain. Now, for the first time, ordinary depositors in Cypriot banks are being asked to take a hit – in the form of a tax of up to 10 percent of their deposits.

Those banks remain closed for an extended holiday as European officials scramble to prevent a bigger run on the country’s banking system, which has been bleeding deposits for the past several months.

In the short-run, the crisis will likely be contained. Though painful for Cypriot consumers and businesses, the potential direct financial losses are too small be felt on the continent or around the world.

But the aftereffects of any panic – no matter how small or localized - are difficult to predict.

So is this going tohurt the global economy?

By itself, no. The gross domestic product of Cyprus is less than Vermont’s. (We don’t mean to pick on Vermont, but it has the smallest GDP of any U.S. state.) So the downward spiral of the Cypriot economy will have very little immediate impact on global trade or investment.

The indirect impact, though, could spread to banks and investors in other weaker economies in Southern Europe. Over the past two years, thanks to a series of bailouts, the long-running crisis facing big borrowers like Spain, Italy, Portugal and Greece had subsided.

This latest bailout of Cyprus – though small in comparison – has revived worries about the long-term outlook for those countries. Despite the infusion of hundreds of billions of dollars, those economies continue to contract. No one seems to have a credible plan to fix the problem. The strategy seems to be to keep them afloat and hope they somehow heal over the long run.

For Cyprus, the crisis has been simmering for some time. But the backlash from the proposal to tax deposits will only make matters worse. The last thing the country needs is a run on its banks. But new depositors are going to be much less interested in putting money in a Cypriot bank if they risk getting back only 90 percent of their money.

So why slap bank deposits with a tax? If the country needs more capital, that seems like a really bone-headed move.
Since the European Central Bank pledged last year to “do whatever it takes” to stabilize the European financial system, there’s been a relative calm in the financial markets there. No one is eager to change that.

But the ongoing bailouts – funded largely by Germany, along with the stronger Northern European economies – have become a major political issue dividing the continent.

Europe's debt-heavy nations argue that those stronger economies benefited from the credit boom that created the crisis in the first place. But taxpayers in Germany and other "donor" countries now picking up the bailout tab insist that people in "debtor" countries should bear some of the pain.

There’s also a growing frustration among Germany (and some European central bankers) that bailout beneficiaries have come to expect that their wealthier neighbors will continue to write big bailout checks indefinitely.

Those checks were a lot easier to justify when the German economy was growing. Now that recession has spread to the core of Europe, ongoing bailouts are a much tougher sell to the German people.

“The Germans are showing – with (Chancellor Angela) Merkel facing the electorate in just six months’ time, that they have reached the end of the rope on bailout stimulus,” said David Rosenberg, chief economist at Gluskin Sheff.

Looks like the U.S. stock market gave this whole thing a big yawn. Why should I care?
The U.S. markets aren’t necessarily the best bellwether for the longer term fallout from the latest flare-up in this crisis.

For one thing, U.S. investments tend to do relatively well in response to short-term scares from overseas. Skittish investors are likely moving money to U.S. stocks and bonds because they’re seen as a “safe haven” when Europe is in trouble. (U.S. investments also get a lift because currency traders flock to the U.S. dollar and away from the euro.)

Related: 'Hands off' say Cypriot protestors to EU bailout plan

That flood of money out of Europe and into the U.S. could accelerate if depositors in other countries worry that the Cyprus deposit tax may become standard procedure for future bailouts elsewhere.

The wider impact in the U.S., though, may be negative if the worries about Europe begin to put U.S. investors, consumers and company hiring managers in a gloomy mood. Much of the stock market’s recent rally – and the improvement in the U.S. economy – has been the result of an improved outlook.

The risk is that the return of the euro crisis could reverse that outlook. The 2008 global credit collapse was sparked by the implosion of a relatively small bank called Lehman Brothers. A decade earlier, the 1998 Asian market collapse was sparked by the collapse of Thailand’s currency, the baht.

Sentiment is a powerful – and often fragile – economic force. Sometimes, it doesn't take much to flip that confidence switch off.