Why Cyprus does matter in the end

Ezra Klein / The Washington Post /

Published Mar 25, 2013 at 05:00AM

The European Union, International Monetary Fund, European Central Bank and Cyprus leaders worked into the wee hours of the morning to avoid a collapse of Cyprus’ banking system. But why does the tiny island nation matter so much? Put simply, what happens to the euro affects the rest of the world.

Confused by all the talk of Cyprus? Don’t be. Here’s the situation in three sentences: The country’s banks were using Russian deposits to buy Greek bonds. The Greek bonds went bad, and the Cypriot banks lost a bundle. It now needs a bailout from its eurozone partners, but it’s tough to convince German taxpayers to pony up if they think the money is going to Russian oligarchs.

But here’s the bigger question: Why are we talking about Cyprus at all?

Cyprus is tiny. It has fewer people than Philadelphia. It has a smaller economy than Vermont. It has no nukes. It is not a country that typically commands global headlines.

But in 2008, exhibiting especially bad timing, Cyprus joined the eurozone. So now its problems are the euro’s problems. And as we’ve discovered in recent years, the euro’s problems are the world’s problems.

In 2011 and 2012, markets seemed in almost constant turmoil over the very survival of the currency union — and their turmoil, in turn, actually threatened the survival of the currency union, as the market became unwilling to lend Italy and Greece and Portugal and Ireland the money needed to fund their governments. But the relative financial calm masks a very dangerous political and human situation.

In Spain, unemployment is at 26 percent, and youth unemployment is above 50 percent. The same is true in Greece. In Italy, an anti-eurozone comedian won more votes than the leaders of either major party, and with no one commanding sufficient support to form a government, it looks as if the deadlock will require a redo election.

Public outrage last week had scotched Cyprus’ initial idea of paying for its bailout with a broad bank tax, and the country scrambled to come up with a new source of funds before today’s deadline set by the eurozone. Working into the early hours of this morning, European and Cypriot officials reached a tentative deal on a bailout for the beleaguered country (see “EU, Cyprus reach tentative deal”).

“My view is that what you’re seeing already is the politics coming unstuck in a lot of places in Europe,” says Desmond Lachman, a resident fellow at the American Enterprise Institute, a Washington think tank. “Greece is the worst example. The extreme left and right has 45 percent of the vote now.”

In 2011, the eurozone’s crises were driven by fearful markets. On any given morning, the people would awaken to find that interest rates on Spanish bonds had soared. Today, the crises are driven by volatile politics, and that makes them all the more dangerous. The European Central Bank can deal with a bond-market crisis. It can’t deal with a popular revolt.

“I don’t understand how you can extend this for many more years,” Lachman says. “The game plan is they apply this fiscal austerity in 2013, 2014 and 2015. And my problem with all this is I don’t see how, if you’ve got significant fiscal austerity at a time when banks are cutting credit and Germany is slowing down and, in Spain, the housing bubble is bursting, I don’t see how this recession ends. And if you don’t have hope? The politicians keep selling the idea that this will hurt a bit but in six months time we’ll see the green shoots. If you don’t see them, you’re just inviting a political mess.”

If you want to fear for the euro, this is the reason to do it. A half dozen countries have unemployment in the 15 to 25 percent range, with youth unemployment in the 30 to 60 percent range. Politics isn’t stable amid that sort of pain — particularly when there’s a perception that some of the pain is being forced upon the country by richer, wealthier outsiders.

That’s what’s happening now. Christopher Pissarides, a Cypriot economist, won the Nobel Prize in economics in 2010. But in an interview with Bloomberg Businessweek, his fury at the more powerful countries in the eurozone was sparklingly clear. “Small countries, be warned when joining the eurozone,” he said. “You could be bullied any time by your big brothers if it suits their political objectives.”

The man on the street, it’s safe to say, is even angrier.

As austerity continues to squeeze these economies over the next couple of years, the political pressure to do something, anything, to recapture national pride and rediscover some measure of hope will build. And once it finds expression — if it finds expression — the chain reaction could be catastrophic for the eurozone.

That’s the other reason a tiny island like Cyprus matters. It shows the eurozone’s tendency toward contagion.

Cyprus’ banks fell because they’d invested in Greek debt — so no Greek problem, no Cypriot problem. The initial idea to pay for Cyprus’ bailout would have included levying a 6.6 percent fee on all bank accounts of less than 100,000 euro.

That was taken, in many quarters, as a violation of the eurozone’s nascent deposit insurance scheme. It raised the possibility that investors in Italy or Spain would need to move their money, too. After all, if deposit insurance doesn’t protect you from the eurozone simply removing money from your bank account, what good is it?

But what killed the idea wasn’t its underlying economic flaws. It was political outrage in Cyprus. So far, these eruptions against the bailout conditions set by the richer members of the eurozone have always proved manageable. But there’s been a number of close calls, and of late, the political situation in many of these countries is deteriorating.

If a country like Greece or Spain were to see a political reaction that made remaining in the currency union impossible, it would immediately spark a run on the other teetering countries, making it more likely they’d have to leave, too. That’s how you get to actual dissolution.

Jacob Funk Kirkegaard, a senior fellow at the Peterson Institute for International Economics, thinks all this is a bit overblown. “The euro is a prison, or a Hotel California,” he says. “Once you’re in, you can’t get out. The costs of leaving are just cataclysmic. They’re so high no one will do it. Greece shows that.”

And thus far, Kirkegaard had been proven right. Elections have produced a lot of anti-eurozone rhetoric, but not a lot of anti-eurozone behavior.

“A lot of people have been predicting the 1930s scenario, where the economic hardship we’re seeing will lead to political extremism, and then lead to the undoing of entire area,” he says. “I take some solace in the elections we’ve actually had. Yes, you’ve kicked out incumbent governments in almost every case, but the government that comes in and replaces it is pretty much the same.”

The question is whether they’ll remain so. It is hard to be confident in a currency union that must fret over the decisions of Cyprus.

EU, Cyprus reach tentative deal

NICOSIA, Cyprus — Struggling into the early morning hours to avoid a collapse of Cyprus’ banking system, European Union leaders early today agreed on the outlines of a bailout package intended to keep Cyprus in the eurozone and rebuild its devastated economy.

The emerging deal, struck after hours of meetings in Brussels, still needs to be approved by the 17 finance ministers from countries using the euro. It would drastically prune the size of the country’s banking sector, whose size, largely built on the deposits of wealthy Russians, dwarfs the size of the tiny island nation’s economy.

The deal would scrap the highly controversial idea of a tax on bank deposits, although it would still require forced losses for depositors and bondholders.

— New York Times News Service

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