Why Cyprus Matters

Cyprus?

It’s population is only slightly larger than San Jose, California. The island nation’s GDP is about half the market cap of CVS, your local pharmacy chain.

And yet, Cyprus is at the center of an EU financial crisis that has the potential to rock global markets, strain geopolitical ties and influence elections on the continent. Cyprus is also a poster child for the implications of financial sector recklessness, government hubris, the reality of the debt bomb and the doctrine of “Too Big to Fail” (TBTF).

Ezra Klein of the Washington Post offers a pithy summary of the current state of play in Cyprus. “The country’s banks were using Russian deposits to buy Greek bonds. the Greek bonds went bad, and the Cypriot banks lost a bundle. Now Cyprus needs a bailout from  its euro-zone partners, but it’s tough to convince German taxpayers to pony up if they think the money is going to Russian oligarchs.”

Worse, before the Germans (and the other EU members) will even deign to bail out Cyprus, the country must come up 75 percent of the loan that the EU will make; $7.5 billion for an EU loan of $10 billion.

But Cyprus’ banks are effectively insolvent.

In the “go-go” days before 2008, when the Greek government was keeping two sets of books, and issuing a flood of sovereign debt that was rated as solid as German bonds, Cypriot banks jumped in with both feet. When Greece collapsed and required an EU bailout in 2010, the “haircut” that the EU bureaucrats mandated of all private sector bond holders impacted Cyprus’s banks disastrously. Billions were lost.

Moreover, the health of Cypriot economy is inextricably tied to the banking sector.  With lax regulation, Cypriot banks became a haven for international depositors seeking higher returns, and potentially a shield to the prying eyes of their host country tax authorities. Cyprus promoted itself as a destination for personal wealth, while the banks continued to make increasingly bad bets.

As a result of this financial recklessness, Cyprus found itself with a vastly over-extended banking sector. In April 2012, the New York Times reported that Cyprus had outstanding loans in excess of $197 billion; about six times the nation’s GDP.

This crisis in the banking sector only further aggravated the national economic impact of the post-2008 financial crisis, on Cyprus, where unemployment spiked and growth dropped, forcing the government to spend increasing amounts on social welfare programs through deficit spending.  Cyprus’ debt to GDP jumped from a manageable 48 percent in 2009 to 87 percent in 2013 – a shocking 81 percent increase in only four years.

Faced with government unable to borrow further, and a financial sector buried in bad debt, Cyprus was forced to request an EU bailout, following Greece Ireland and Spain.  But a bad situation was made worse by Cypriot government decision makers who proposed that of all the collateral that the country could put up, it would be depositors pick up the tab for government and financial sector recklessness.

Imagine for a second if Presidents Bush/Obama had sought to pay for the TARP bailout of the banks by taxing American savings immediately and directly. In the case of Cyprus, the government proposed a tax of 6.7 percent on deposits up to $130,000 ($8,700 max) and 9 percent on accounts with larger balances.

The furor by average Cypriots signaled the obstacles to the plan, which went down to unanimous defeat in the Cypriot Parliament,  but the implications of the blueprint immediately sparked a potential systemic and geopolitical crisis.

First, since the beginning of the EU crisis, country regulators have left bank deposits alone. Taxes have gone up, government spending has been cut. Bond values have been slashed. But to avoid stoking capital flight, the EU nations have left savings alone.

Until now.

So if you are a citizen in Greece, or Spain, or perhaps even Italy, what kind of precedent does the Cyprus example set? Are your savings safe? The economic situation in these countries rates as barely tolerable with unemployment in Greece and Spain at 25 percent (youth unemployment at near 50 percent). While EU cash infusions have kept Spanish bond ratings within acceptable parameters, the housing bubble in Spain, and the government’s steadfast refusal to address it, threatens to pop.  The stability of today is fleeting and tenuous with the uncertainty that is just down the road.

Thus, by opening the doors to levies on savings, Cyprus has unwittingly re-opened the door to EU instability by instigating the very grass-roots capital flight that the EU has worked so hard to avoid over the last three years.

And that complication is separate from the geopolitical reality that up to 40 percent of deposits in Cyprus are held by foreigners – most of them Russian. Since the proposed $10 billion EU loan is designed to keep the Cypriot banks solvent and operating – at least for now –  Russian oligarchs are ironically serving the dual role as collateral for a loan that will bail out their longer term financial interests.

Of course the Russians are not interested in playing either role, and the Russian government is looking to th EU to clean up a mess of its own making in its own house, without reliance on Russian wealth hidden away in Cyprus. Indeed, the law of unintended consequences reveals that had EU regulators not imposed the crippling terms required of private bond holders of Greek debt, the situation in Cyprus today would not be as dire.

Now EU Russian relations hang in the balance regarding what path Cyprus and the EU take next.

The Cypriot financial crisis also raises again, profound questions about the limits of democracy to manage harsh economic reality.

Presented with massive protests, the Cypriot Parliament voted down the depositors tax, even though doing so directly jeopardized the EU loan upon which everything depends.

In Germany, Angela Merkel, who has effectively steered the EU through the sovereign debt crisis for the past three years, faces unaccustomed domestic limitations on her ability act.  Up for re-election this year, Merkel can no longer depend on the votes of the opposition Social Democrats – who favor Merkel’s pan-Euro policies but wish to replace her as Chancellor.  The Social Democrats have in fact taken up the line that a loan to Greece is effectively a bailout of Russian oligarchs, making a push for an EU loan to Cyprus all the more difficult.

In addition, seeds of German domestic resentment to years of bailouts has manifested itself in a new political party made up of the most mainstream of German factions – bankers and businessmen – who see no end to the bailouts and no structural change from the countries receiving them, and are willing to support a radically different vision of Europe that effectively cuts the indebted nations of southern Europe free from the monetary union.

In Italy, a recent national election led to a political stalemate with no party able to command a majority, paralyzing efforts to reform Italy’s economy, and putting doubt on Italy’s commitment to EU spending and debt targets. In Greece, where the crisis began – and continues –  45 percent of voters now align with radical parties of the left and right that are well outside the mainstream. European austerity is not bringing stability and improvement, but stagnation and division. This is a growing and dangerous problem for the EU writ whole.

The Cyprus-EU crisis is a microcosm of the crisis in Western civilization.

How long will we tolerate spending beyond our means? How long will we tolerate generational theft to fulfill increasingly unrealistic government guarantees? How long will we reward the reckless and punish the victims under the rubric of TBTF? Are a free people, addicted to the unsustainable narcotic of a “free lunch,” capable of making pain-inducing choices for the greater good?

It is happening there now.

It is going to happen here next.