By destroying Cyprus’s bank-centric business model and by imposing severe austerity on the country within a euro straitjacket, the International Monetary Fund–European Union bailout package for Cyprus is likely to lead to the literal collapse of the Cypriot economy over the next year and to Cyprus’s exit from the euro. Such a course of events will have important ramifications for the rest of the European Monetary Union. When the dust settles and future historians seek to draw lessons from Cyprus’s sorry experience in the euro, they will likely draw the following conclusions.

 

Lessons for Cyprus

1. Joining the euro was a tragic mistake.

Before joining the euro, Cyprus should have considered that its banking- and tourism-based economy had nothing in common with the rest of the European economy. It should also have recognized that if its economy got hit by a major negative external shock, Cyprus would not be supported by fiscal transfers from the European Union or by lower European Central Bank (ECB) interest rates. Cyprus is now paying a very high price for this mistake, as its economy is likely to contract by at least 25 percent over the next year.

2. Allowing unregulated banks to grow so large was a blunder.

It is bad enough that light regulation of the Cypriot banking system allowed that system to grow to more than seven times the size of the Cypriot economy, mainly due to large Russian deposit inflows. However, it is unconscionable that the bank regulators allowed Cypriot banks to buy Greek government bonds amounting to 150 percent of the size of Cyprus’s GDP. This combination was an accident waiting to happen — and it did happen when the Greek government defaulted on its bonds in 2012. The net result was bank losses close to €10 billion, or 60 percent of Cyprus’s GDP.

3. Trying to tax small insured depositors was a monumental error.

It is unconscionable that the bank regulators allowed Cypriot banks to buy Greek government bonds amounting to 150 percent of the size of Cyprus’s GDP.

The Cypriot government’s proposal to impose a 6.75 percent tax on small insured bank deposits was a huge economic and political blunder. Although the proposal was eventually withdrawn, it had a very large impact on consumer confidence. It had an even greater cost for the new government’s credibility and popularity, considering that the proposal would have potentially impacted 90 percent of the Cypriot population.

4. Basic restructuring and large fiscal tightening are not possible within the euro straitjacket.

By requiring a large write-down of the biggest Russian deposits at Cypriot banks, the IMF-EU bailout package has totally destroyed the bank business model on which the Cypriot economy was based. At the same time, the IMF-EU bailout program is compounding the major supply-side shock to the Cypriot economy by requiring that Cyprus adopt budget cutting measures totaling 7.25 percent of GDP over the next three years. The basic lesson that Cyprus is about to learn is that an economy cannot be radically transformed away from banking and toward tourism in a euro straitjacket without destroying the domestic economy. This is particularly the case when an economy is also being subjected to massive cuts in the government’s budget without the benefit of a cheaper currency to boost the tourism and export sectors.

5. Cyprus missed a good opportunity to leave the euro.

Countries in a currency union generally shy away from reintroducing their own currency for fear of precipitating a bank collapse and of being forced to impose stringent capital controls. This makes it all the more difficult to understand why Cyprus has delayed the inevitable reintroduction of its own currency. After all, its IMF-EU-induced banking fiasco has already resulted in a two-week bank holiday and the imposition of capital controls. Cyprus should have at least gotten the benefit of a new currency out of this fiasco.

 

Lessons for Europe

6. Europe should have reserved the euro for core countries only.

In 2008, Europe made a massive error by admitting Cyprus as a euro member. By doing so, it welcomed into the union yet another country whose basic structure differed from that of the core European countries and whose ability to comply with the discipline of the euro was questionable right from the start. Should Cyprus now choose to leave the euro, it will throw into question the European mantra that the euro is forever and there is no possibility of exit for a country once it has joined the currency. A Cyprus exit is likely to be very unsettling for Greece, Italy, Portugal, and Spain. It would have been better not to have admitted Cyprus in the first place.

7. Going along with the tax on small depositors sent a bad signal.

The basic lesson that Cyprus is about to learn is that an economy cannot be radically transformed away from banking and toward tourism in a euro straitjacket without destroying the domestic economy.

The ECB and the European Commission made a grave error in allowing the Cypriot government to introduce a bill that would have taxed small insured depositors. By going along with the Cypriot proposal, they threw into question the security of small bank deposits in the rest of the European periphery. This remains the case even though the proposal was ultimately defeated in the Cypriot parliament and statements were made by European policymakers that small insured deposits are safe. It seems that the damage to European policymakers’ credibility has already been done.

8. Suggesting that bailing in large depositors could serve as a template for future bailouts will likely be costly for the EU.

As part of the IMF-EU bailout package for Cyprus, large deposits of over €100,000 were written down by around 60 percent. Loose talk among European officials suggesting that the Cypriot bailout could serve as a template for future European bailouts is likely to prove a costly mistake. In anticipation of a possible future bailout, capital flight will increase in the rest of the European periphery, which will only make the next bailout more difficult to effect.

9. Cyprus should have been encouraged to leave the euro.

By designing yet another bailout package that has failure written all over it, the IMF, the EU, and the ECB are about to further damage their already diminished credibility. It would have been better for them to have faced up to Cyprus’s inevitable exit from the euro right from the start and to have sold a Cyprus exit as a special case, rather than associating Europe with yet another bailout program that will fail in short order. This diminishes the ability of the troika to deal with future European crises.

10. German Chancellor Angela Merkel has limited room for maneuver.

Chancellor Merkel was forced by domestic German politics to impose a draconian bailout package on Cyprus and to severely punish the Russian bank depositors. The fact that she went along with a program that will effectively destroy the Cypriot economy as opposed to writing the Cypriots a blank check is a measure of how constrained Merkel has become in her dealings with the euro zone debt crisis. This does not bode well for the prospects that Merkel will either ease the fiscal austerity being imposed on the European periphery or move more quickly toward a European banking union ahead of Germany’s September 22 elections.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

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