As Goes Cyprus, So Goes the European Union

All of a sudden, tiny Cyprus is making headlines. How could such a small country, with an economy approximately the size of the State of Maranhao, create such big problems?

The answer is that the crisis in Cyprus epitomizes everything that is wrong with the European Union.

Most fundamentally, there is the very fact that Cyprus was allowed to adopt the euro in 2008. It was already an offshore money-laundering center. Even after problems struck other European countries with oversized banking systems, the EU looked the other way when Cyprus offered high interest rates in order to attract additional hot money. It looked the other way when the banks loaded up on high-yielding Greek debt.

The big Cypriot banks all passed the EU’s bank stress tests with flying colors in the summer of 2011, which seems incredible with hindsight. The government had already lost market access, and it was clear that it would require a bailout. It was clear that Greece would restructure its debt and that this would punch a hole in the balance sheets of the banks. In July 2011 the largest power station on the island then blew up, literally, because the government in its wisdom chose that spot to store live ammunition.

For all these reasons, the writing was on the wall. But no serious negotiations were undertaken for the next year and a half. Cypriot officials didn’t want to admit their negligence, while the European Commission for its part didn’t want to negotiate with a Communist-led government. When negotiations finally commenced last month following the election of a new Conservative government, they took place under severe pressure of time.

But this is no excuse for the ham-handed nature of the package. The Cypriot authorities sought to preserve a broken business model – to hold onto their big Russian deposits by taxing small depositors. They are heavily responsible for the panic that ensued.

But nothing forced the European Commission, the ECB and the IMF – the members of the so-called Troika – to agree to a plan that called into question the inviolability of deposit insurance. The IMF had spent years studying the optimal design of deposit insurance. As we speak, the Commission and the ECB are pondering the design of a common deposit insurance scheme as part of their prospective banking union. Now there are doubts about the safety of small deposits not just in Cyprus but in Italy, Spain and throughout the European Union.

The euro group and its new head, Dutch finance minister Jeroen Dijsselbloem, deserve special recognition. It is the nature of the euro group that the chairman is appointed for two years. Unfortunately, a new, inexperienced chairman was appointed at the worst possible time. By first asserting and then denying that the Cyprus depositor bail-in was a template for how the EU would manage subsequent crises, Mr. Dijsselbloem created high anxiety about the future and raised the likelihood that more bank runs and crises will follow.

The ensuing panic has called into question the very survival of the single currency. To halt depositor flight, Cyprus has been forced to impose capital controls. As any Brazilian knows, once capital controls have been imposed they are very hard to remove. The idea that they will be taken off after a week or a month is fanciful. Those controls make a euro deposit in a Cypriot bank worth less than a euro deposit elsewhere. So much for the principle of a single currency. And so much for the “three freedoms” – free movement of not just goods and people but also capital – that EU membership is supposed to confer.

What should have been done instead? EU authorities were right to acknowledge that loaning large amounts of money to the government so it could bail out the banks was no solution, since this would have saddled the sovereign with unsustainable debts. But they were wrong to insist that the government immediately write down bank deposits, even large deposits above €100,000, since doing so meant destroying at a stroke the financial sector that was the Cypriot economy’s most important business. It consigned Cyprus to a depression of historic proportions.

Instead, EU leaders should have acknowledged that Cyprus hadn’t gotten into this mess without their help. The EU had looked the other way when Cyprus adopted the euro. It looked the other way when its banks went after Russian money. It even gave those banks its seal of approval. The EU should therefore have used its rescue fund, the European Stability Mechanism, to inject funding directly into the banks, repairing their balance sheets. Over time, the banks could have been downsized. Standards for foreign deposits, from Russia and elsewhere, could have been tightened. The problem could have been solved without bankrupting the country.

This approach would have come at some cost to other EU countries. But that cost would have been small, given Cyprus’ small size. And cost sharing would have been fair and just, given the role of the EU in allowing the problem to develop. But this presupposes European politicians willing to make the case to their constituents. It imagines an EU in which decisions are driven by economic common sense and not by Germany’s impending elections.

That, of course, would be a very different EU than the one we actually have, in turn raising the question of whether the actual existing EU can survive.

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