The latest news out of Cyprus – the government levying taxes on bank account holders – is very, very interesting.

If you understand it on a deep level, Cyprus’s actions cut to the core of whether we are going to live in a socialist world or a capitalist world. Banking is at the center of the economy, and the policies you set in banking determine who gets capital and under what conditions. That’s the definition of capitalism: how to allocate capital and under what terms.

Right now, the world is completely socialist, because every deposit and every bank is government-guaranteed.

Do you remember the first thing that happened during the fiscal crisis of 2008 and 2009?

The Feds said, “You have to have higher deposit guarantees.”

With higher guarantees, there was no reason to have a run on banks. In the case of a bank failure, every depositor would get every penny back.

The Fed had to increase its deposit guarantees, because when the first couple banks failed, the Federal Deposit Insurance Corporation (FDIC) limits were $100,000. Some people lost money. Because of that, people were moving money around to different banks.

After the crisis, the FDIC raised the limit to $250,000.

The 2008 crisis happened because banks made bad lending decisions and lost money. But who should be responsible for those bad lending decisions? Is it the bank and its depositors or is it the taxpayers? In capitalism, you have to be responsible for your own economic choices. That’s how the economy is guided.

And if you allow people to make economic decisions without consequences, you’ll end up with a lot of malinvestment. You’ll have a dysfunctional economy. And that’s what we’re seeing in the world today, because nobody is responsible for their bad decisions. Problems get papered over (thanks to government bailouts), and society as a whole pays for them in the form of inflation.

In Cyprus, the European Union tried telling every depositor to pay a tax of 10 percent to cover the losses in Cyprus’s banks. And depositors said, “Hell no! We’ll take our money out of the bank so you can’t tax us.” It’s interesting that bank runs are caused by regulators today – because at the end of the day, they control everything. That’s socialism, not capitalism.

What happened in Cyprus doesn’t have any direct implications for the U.S. banking system. Our banking system is already so thoroughly socialist, we won’t have any runs on the bank. We have the printing press, we have the reserve currency and we have Fed Chairman Ben Bernanke, who will print as much money as he feels is required at any time.

But realize something: If we were truly living in a capitalist world, who you choose to bank with (where you choose to place your cash) would become an important decision. You would want to bank with people who make wise lending decisions. Today, you don’t have to think about your bank, because your money is always guaranteed. There’s no consumer preference for well-run banks. And if there’s no preference for well-run banks, you’ll get a bunch of crummy banks, which is what we have. And crummy banks make crummy loans.

For example, today automaker General Motors can lease cars to subprime borrowers. There’s no way these subprime borrowers should be allowed to get a new car. It’s absurd. And yet, because there is no consequence to making a bad loan (or lease, in this case), that’s how the economy operates. This is a big mistake.

We’d be much better off if people had to be responsible for their own economic decisions – and that starts with where you put your money in the bank.

But we don’t have that. We haven’t had that kind of freedom in the U.S. since before the Great Depression, and it’s a shame. In places where you have free banking – like Hong Kong and Switzerland – you have much better economies. You have much better per capita GDP growth, more wealth and more freedom.

The lesson of the Cyprus bank levy is that you can’t have a system in which depositors face no risk. If there is no risk, there is no incentive in the economy for making wise capital-allocation decisions. Therefore, the economy will become stagnant, and there will be no growth or wealth created.

Think about it this way: What if the government were to guarantee the dividend payments from every Fortune 500 company? So no matter how bad the product development was, no matter how bad the marketing was, no matter how many people were employed who shouldn’t be, the government would always guarantee the dividend payments.

There would be no reason for management to do a good job or make wise decisions.

Ask yourself: Where would the economy be if the government guaranteed everything?

The economy would be in the toilet very quickly. For an economy to function properly, there has to be a risk of loss. For an economy to grow, you need consequences for failure, just as you need positive incentives for success. Today, we live in this incredibly phony world where there is no punishment for failure (for either depositors or bankers). It’s insane.

So how do we right this ship? Unfortunately, you’d have to go back to the beginning and not guarantee deposits.

Look at the U.S. banking system. Look how much capital is deposited in U.S. banks versus the actual reserves at these banks.

Bank of America, for example, holds $1.1 trillion in deposits. Against that, it holds $457 billion in liquid assets – a $643 billion shortfall. Withdrawal requests are instantaneous. It would take the bank much longer to actually sell those assets in order to meet withdrawals. And should that situation occur, the value of the assets it’s liquidating would be impaired.

The Federal Deposit Insurance Corporation is the entity responsible for insuring bank deposits. But it doesn’t have any money. The whole thing is a mirage. The power of the printing press is the only thing standing behind this insurance.

If you were actually going to insure that capital, banks would need vast reserves. No insurance companies are big enough to insure the U.S. banking system’s deposits. There’s nowhere to put all the money. But this is a sign of fractional reserve banking and the paper-money system we have today.

This is what leads to inflation. It’s the cause of business cycles. And it’s what will inevitably lead to some kind of collapse.

Do I think the issues in Cyprus are the beginning of the collapse? No, it’s just part of the process. The collapse began in 2007 with the demise of the subprime mortgage market. That led to the collapse of the prime mortgage market in 2008, which led to the collapse of Lehman Brothers and Bear Stearns.

If it weren’t for the government printing press, we would have seen a global run on the dollar and a collapse of the global banking system. We’re still suffering the consequences of these things today. So I don’t know exactly where we are in terms of the timeline – maybe the sixth or seventh inning.

But when this process ends, we’ll see a total flight from the U.S. dollar, because the dollar underlies the entire banking system (whether in Cyprus or the U.S., all reserves are in dollars). Eventually, people will flee the dollar system as a whole.

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