Europe’s Cyprus Blunder and Its Consequences

The late Mike Mussa of the Peterson Institute, a former Chief Economist of the International Monetary Fund (IMF), noted about some episodes of the late-1990s Asian financial turmoil that “there are three types of financial crises: crises of liquidity, crises of solvency, and crises of stupidity.” This quip comes to mind when considering the developments of the past few days around Cyprus.

The March 16 announcement of an agreement backed by most European leaders and institutions as well as the International Monetary Fund (IMF), which called for a tax (or possibly an unfavorable cash-for-equity swap) on holders of bank deposits, no matter how small, was a policy blunder likely to cost the European Union  dearly.

The sequence that led to this “Saturday-morning plan” is well known. Greece’s sovereign debt restructuring a year ago hit Cypriot banks that had bought Greek bonds, raising doubts about the Cypriot government’s own solvency. Negotiations on a possible bailout by the European Union had been seen as inevitable as early as mid-2012. But discussions were frozen until a general election in Cyprus last month. Unfortunately, the delay pushed the timetable of negotiation into German election cycle territory, constraining the latitude of the euro group, in which Germany is now the unquestioned central actor. Driven by the domestic German political debate, European negotiators were intent on forcing losses on large (read Russia-linked) Cypriot deposits as an indispensable component of the package.

To the surprise of many, the recently elected Cypriot president, Nicos Anastasiades, added a further twist to the tangled situation by suggesting a hit to small depositors as well. According to some reports, he wanted to limit the losses imposed on large depositors in order to preserve the island’s future as an international financial center. All negotiators seem to have accepted this offer before realizing, too late, how damaging it might be to trust in the safety of bank deposits well beyond Cyprus.

No easy or painless option was available for Cyprus. However, some of the Saturday-morning plan’s flaws were avoidable.

First, the plan disregarded the lessons of financial history about the high importance of deposit safety, particularly for middle-class households (which is why there usually is an upper limit for explicit deposit insurance, harmonized at € 100,000 in the European Union since 2009). Based on the experience of the early 1930s, it is virtually undisputed in the United States that a breach of deposit insurance will primarily hurt the “little guys.” Sheila Bair, the respected former Chairman of the US Federal Deposit Insurance Corporation, has expressed this view with reference to Cyprus. Similar lessons arise from the record of many recent emerging-market crises.

If it is true, as alleged, that Cyprus’s own president was the one who recommended hurting small depositors, European negotiators were not justified in going along. After all, in November 2010 the Troika of the European Union, the European Central Bank (ECB), and the IMF rebuffed the Irish authorities’ proposal to “burn” the holders of senior unsecured debt in failed banks. Their concern was to prevent damaging contagion in the rest of Europe. A similar argument was more straightforward and sensible for Cyprus than it had been for Ireland, and should have led them to oppose Anastasiades’ proposal from the outset.

Second, the festival of finger-pointing in Brussels and across Europe following the Cyprus debacle shows that the negotiators had no “plan B” were the Cypriot Parliament to reject their initial scheme. One must wonder whether the European Union is ready to handle the complex Russian side of the Cypriot equation, including the wisdom of depending on Russian goodwill for a solution to the current mess.

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