Forget Cyprus – This Is a MUCH Bigger Threat to Europe

Forget Cyprus – This Is a MUCH Bigger Threat to Europe

Investors aren't exactly thrilled with the breathtakingly shortsighted "bail-in" Europe has imposed on Cyprus.

This is a rescue in name only. In reality, it will gut the Cypriot economy and set a nasty precedent throughout the rest of the eurozone.

Rather than cough up €5.8 billion ($7.4 billion) to save Cyprus (a measly 0.05% of EU GDP) European leaders prefer to see the Cypriot government confiscate 40% of Cypriot bank deposits over €100 thousand.

It will drive Cyprus into a depression, much like the "rescues" of Greece, Spain, Ireland and Portugal have done. That's because the deal utterly destroys the credibility of Cyprus' banking sector, which makes up 45% of Cypriot GDP and employs 70% of its workers.

Europe's mantra is that Cyprus is a "special case" because it is a tax shelter for Russian oligarchs' cash. About one-third of Cypriot bank deposits come from Russian depositors. But the claim that all of this cash is illicit is pure nonsense. It is widely believed because it plays into a stereotype of Russians as corrupt gangster types.

Scratch the surface and a different story emerges...

First, Russia has a 13% flat-rate income tax and a 20% corporation tax. So the need to "dodge" taxes isn't exactly pressing.

Second, about 40,000 Russians call Cyprus home. There may be some shady types among them. But it's a stretch to claim that the majority of them are corrupt oligarchs who deserve to have their savings robbed. Russia has cold winters. Cyprus sits in the Mediterranean and is warm all year round.

Third, Cyprus and Russia have a double-taxation treaty. This puts a 5% cap on taxes on interest and means an effective 0% rate on dividends and royalty payments. So why wouldn't Russians seek out these terms? You don't have to be crooked to want to reduce your tax exposure.

But Merkel, Draghi et al. need a scapegoat. And they have found one in the Russian mob.

But the Cyprus story is a diversion. The real threat to Europe right now is Italy.

To say Italy is on the brink is an understatement.

The big winners of the recent Italian elections were a former Communist, Pier Bersani; a former comedian, Beppe Grillo; and a disgraced former politician, Silvio Berlusconi.

And they utterly rejected the caretaker prime minister, the market-friendly technocrat Mario Monti.

The level of political disarray and disillusion in Italy (where I write to you from today) is hard to believe.

Monti has said that his government "can't wait to leave office." And Bersani has said that "only an insane person" would attempt to rule Italy in the current environment. Meanwhile, Grillo, who cannot hold office because of a manslaughter charge against him, has announced that Italy doesn't need a new government to pass reforms.

He is also on record as saying that his anti-austerity and anti-establishment Five Star Movement wants to "destroy everything." He will also push through a referendum on leaving the euro if he gets into government.

If either Berlusconi or Grillo gets into power, the markets will panic.

Already investors are selling Italian and Spanish sovereign bonds and buying safe haven German bunds and U.S. Treasury bonds. This is a slow drip right now. But it could easily turn into a torrent, if either Grillo or Berlusconi seizes the reins of power in Italy.

Bottom line: Another European summer of chaos and crisis is very much on the cards. This will not only throw European markets into disarray, but also cause investors in U.S. stocks to run for cover.

U.S. stocks have already more than doubled since their March 2009 lows. Wading in right now could prove to be horrible timing.

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