The Eurozone’s Gambling Problem : Rolling the Dice on Cyprus

Sous la contrainte des événements, les dirigeants européens ont choisi la voie la plus risquée pour tenter de sauver Chypre, estime Douglas J. Elliott, dans un commentaire pour la Brookings Institution de Washington.

In Cyprus, the eurozone’s leaders are yet again gambling the future of the currency zone through an excessively risky move. As is too frequent in the euro crisis, cruelly binding political constraints blocked the most sensible approach. Instead, they have chosen a path that may get them through the next period while laying the seeds of a worse trouble down the line. They may get lucky, but they are increasing the vulnerability of the currency zone to a future wave of crisis. (In due humility, we must note that U.S. politicians are not strikingly better at these types of decisions.) 

The Cypriot government was about to run out of money and the banking system needs a bailout that is too large for the state to support in the long run, even if it could borrow the cash now. The best solution would have been a eurozone rescue on fairly lenient terms, as an interim solution if not a longer-term one. The country is very small ; its economy is only about one half a percent of the total in the eurozone. A pragmatic rescue would have paid dividends in increasing the zone’s stability at a critical time when problems in Greece, Italy, Spain and elsewhere are worsened by political constraints created by the run-up to Germany’s September federal elections.

Those same German political constraints, echoed in other of the stronger eurozone nations, rendered the straightforward approach infeasible. German voters already start out skeptical about committing their financial support to an ever-increasing list of eurozone recipients. Cyprus is indeed small, but there were fears that too much generosity would set precedents that might be applied to much larger countries in the future, such as Spain or Italy. These concerns might have been overcome by the modest size of the needed support and the argument that Cyprus and its banks have suffered heavily from the eurozone’s treatment of Greece, with which Cyprus has close ties. This includes the drastic haircut on the value of Greek government bonds owned in substantial amounts by Cypriot banks.

However, Cyprus has an oversized banking system bloated by very large inflows of deposits from Russia and Ukraine that are perceived to be from dubious characters using the nation for money-laundering and tax evasion. German and other national leaders felt they could not ask their people to support a bailout of Russian oligarchs without corresponding sacrifices from the beneficiaries.

Imposing losses on the holders of Cypriot government bonds would have achieved the political purpose, but doing so in Greece was disastrous and the zone’s leaders have rightly sworn that this will not happen again during the current crisis. Bondholders of the banks needing rescue could have been hit with large losses, and probably will be, but Cypriot banks were awash in deposit money and therefore borrowed relatively little through the more expensive bond market, rendering the savings from writing off those bonds fairly small. Russia was approached to join the rescue, and probably will provide support in low-key ways, but was unwilling to provide the volume and visibility of aid that would have served the political need.

That left the depositors to make sacrifices. eurozone leaders were well aware that forcing losses on depositors of struggling banks would increase the risk of bank runs in other troubled countries if the public started to lose confidence in their finances. Yet they saw no other politically feasible solution, so they tried to be clever. They chose to impose a uniform tax on depositors of all banks, rather than a haircut related to the size of each bank’s losses. Presumably this is to avoid the precedent of depositor losses by framing the action as a one-off wealth tax, but it is hard to believe anyone but lawyers will make the distinction.

There is a grave risk that this action will eventually lead to serious bank runs in other parts of the eurozone. A depositor in a weak country with a troubled banking system would have to seriously consider moving their funds to a stronger country, which is easy to do within the eurozone, or out of bank deposits altogether, which is even easier. European leaders can repeat until they are blue in the face that the unique circumstances of Cyprus are the only reason they went this way, but many depositors will focus on the fact that even insured deposits are being hit. Nor is the relative health of one’s bank relevant to the loss, so it will not necessarily be better to hold deposits in a safe bank.

The eurozone keeps gambling on risky, politically expedient solutions to deal with the problems that are directly in front of it. Sometimes this has worked and sometimes, as with the Greek bond haircut, the longer-term consequences are disastrous. The eurozone may get lucky this time, either because the euro crisis is near its end or because there will be no further bank panics. However, I fear neither of those fortunate situations will prove to be true.