Jazz noted yesterday that the EU bailout of Cyprus broke new ground in the European debt crisis — which should have every participant in the Western economy worried. As part of the bank rescue in the small island nation, the Cypriot government will seize a percentage of deposits to pay off the country’s steep debt.  As Cypriots started a run on their banks, creditors are now trying to head off a panic by tweaking the levy:

Cyprus and its prospective international lenders are considering altering brackets on a one-off deposit levy agreed to as part of a bailout deal reached Saturday that will see savers suffer losses in exchange for the country’s EUR10 billion bailout, an official with knowledge of the situation said Sunday.

The plan that is currently under consideration will leave the target revenue of the extraordinary levy unchanged at EUR5.8B but will seek to protect smaller depositors.

According to the official a new plan would see deposits up to EUR100,000 taking a loss of under 5%; of EUR100,000 to EUR500,000 under 10%; and over EUR500,000 of about 13%.

The original deal that Cyprus struck with its euro-zone peers and the troika of the European Central Bank, the European Commission and the International Monetary Fund is to impose a one-off levy of 6.75% to all deposits up to EUR100,000 and of 9.9% to those above.

First, I doubt this will make Cypriot depositors change their minds about the deal and their strategy to handle it.  Regardless of whether it’s 6.75% or 5%, any money left in those accounts will be less than if depositors stick cash in their mattresses.  Even if they can’t get all of their money out, they can at least get some of it out, and the wealthier depositors will probably have more resources for transfers.  All of that means that (a) the run on banks will continue, and (b) the EU isn’t going to get its €5.8 billion from the confiscation.

Second, this strategy seems bizarre for a plan to keep the Cypriot economy stable — and that of the greater EU.  The problem in Europe isn’t too many deposits — it’s too much debt.  Banks need their liquidity to ride out the crisis in the long term, and besides, this looks very much like punishing the innocent for the sins of the guilty.  It will hammer older people more, creating more pressure on social-welfare programs to fill the gap, and those programs are the big long-term problem in the EU debt crisis as it is.

As Europeans look at this precedent being set, they should be asking themselves this question, especially in Rome, Madrid, and Lisbon: are we next? Don’t be surprised if depositors start to move away from European banks and look for other options to protect their savings from the governments that can’t solve their spending problems.  They may start altering the deal before it arrives on their doorstep.