Why Tiny Cyprus Matters to Europe

By Desmond Lachman, Resident Fellow at the American Enterprise Institute

Cyprus is the smallest of island economies. At barely one million inhabitants, its population is minuscule and its economy constitutes a mere 0.2 percent of the overall European economy. Yet what is happening in Cyprus could have enormous implications for Europe’s economic future and for the very survival of the euro itself. For the rest of Europe must be expected to draw lessons from Cyprus as to how future European crises might be handled.

The Cypriot crisis is yet one more crisis in a sequence of crises that has riddled the eurozone since the beginning of 2010. First we had the Greek crisis, then we had one in Ireland, another in Portugal, and yet others in Spain and Italy. As each of these crises erupted, European policymakers solemnly assured us that they were one of a kind and that they were unlikely to be repeated.

Euro in crisis?

The eruption of yet another crisis in Cyprus risks putting a lie to those soothing reassurances. It also revives nagging questions as to whether the euro itself might be fundamentally flawed. Might the euro constitute too rigid a straitjacket for countries in the European periphery to correct their unsustainably large public sector deficits and their large external imbalances? Imposing fiscal austerity on the periphery in those circumstances only seems to drive the periphery ever deeper into economic recession, which sets up Europe for its next economic and political crisis.

It has also not helped confidence in the euro that the Cypriot crisis has erupted at a time when other troubling problems are now raising their ugly heads in Europe. Less than a month ago, the electorate in Italy, the euro area’s third largest economy and a country with around EUR 2 trillion in public debt, voted overwhelmingly against austerity and structural reform. And it did so in a way that has led to a political stalemate and to the prospect of new elections within the next six months. Experience would suggest that this is more than likely to lead to policy gridlock in Italy for the rest of this year, which will sap investor and consumer confidence in an Italian economy that is already deep in economic recession.

Meanwhile, the deep economic recessions afflicting Greece, Italy, Portugal, and Spain have all gathered pace and are now giving rise to increased social and political tensions in those countries. Against this backdrop, the last thing that Europe needed was yet another crisis that could further erode confidence in the euro’s longer run future.

Policy blunders don't help

More troubling yet for the euro’s future has been the egregiously inept way in which the Cypriot crisis has been managed. In what has to constitute the biggest policy blunder in the euro crisis to date, was the introduction of a bill in the Cypriot parliament that would have taxed small insured bank depositors at the rate of 6 ¾ percent in an effort to recapitalize the Cypriot banks. And remarkably this bill was introduced with the blessing of Angela Merkel, the German Chancellor, as well as with that of the European Commission and the IMF.

In the event, the proposal to tax small depositors unleashed a virulent domestic political backlash that forced the resounding defeat of that bill in the Cypriot parliament. However, it is more than likely that major long-term damage has been done to the rest of Europe. For it will not have been lost on bank depositors in Italy, Portugal, and Spain that insured deposits might not actually be really insured and that in the event of a bank crisis at home those deposits might also be taxed.

In a similar vein, long lines outside Cypriot banks as depositors scrambled to withdraw deposits, as well as the subsequent imposition of strict capital controls to stem very large capital outflows, will have done little to engender confidence in the European periphery. At the first sign of renewed trouble in the rest of the European periphery, one must expect depositors to consider bolting to safeguard their deposits, which would complicate the banks’ problems in those countries.

Yet another way in which small Cyprus might have adversely impacted the resolution of the European crisis is that it might have constrained Angela Merkel’s room for maneuver in handling that crisis ahead of scheduled German elections in September 2013. In particular, with the need for bailing out yet another country and with a German electorate now suffering from bailout fatigue, the Cyprus issue might have limited Mrs. Merkel’s room to ease up on the fiscal austerity that is being required of the periphery and that is driving the European periphery ever deeper into recession.

Only time will tell how the Cypriot crisis will affect the course of the euro crisis. However, when the history of the Euro crisis is written, one cannot exclude the possibility that small Cyprus will be seen to have been the last straw that broke the euro camel’s back.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.