Cyprus’s Plan B is still a disaster

The first attempt to bail out Cyprus was such a shambles that the second looks smart by comparison. It’s getting generally favorable press, too — the best available option under the circumstances, and so on. Yes, it’s an improvement. It’s hard to think of anything that wouldn’t be. That doesn’t make it a good plan.

The new deal has removed the craziest part of the agreement reached March 16 — the plan to default on deposit insurance. Let’s not dwell any further on that insanity. But the new plan still has features that, seen in any other context, would surely arouse surprise.

For instance, the so-called troika of the European Commission, the European Central Bank and the International Monetary Fund wanted to be sure that the new debt Cyprus is about to take on will be sustainable — meaning, presumably, that Cyprus will be able to repay it. Yet, by writing down high- value deposits, the revised plan will also cause a sudden contraction of the Cypriot banking system, and thus of the whole Cypriot economy, which depends on banking to an unusual degree.

Those debt projections of which the IMF is so fond? The arithmetic that invested 5.8 billion euros ($7.4 billion) of deposit taxes (to curb the need for new borrowing) with such awesome significance? Forget them. The denominator in the debt ratio is gross domestic product, and Cypriot GDP has just been programmed for precipitous decline. While the IMF was fiddling with its now-irrelevant spreadsheets, European Union finance ministers were actually concerned not with the sustainability of the new debt — that is, with Cyprus’s capacity to repay — but with the short-term political imperative arising from “bailout fatigue.”

The need to shelter EU taxpayers from the consequences of Cyprus — or the need at least to give the appearance of sheltering them — is the crucial circumstance in “the best available option under the circumstances.” Let’s understand, however, that this self-imposed constraint ruled out every sensible option. Europe’s leaders should have grasped that fact and explained it to their voters. Their failure to do so shouldn’t be accepted as the sadly inevitable consequence of exhausted electorates. It should be recognized as an inexcusable deficit of leadership, and as a mortal threat to the whole euro project.

I’m certainly not defending the Cypriots’ distended banking system. That needed to be reformed. Bailing in creditors (including uninsured depositors) of failing banks is desirable — so long as it doesn’t cause systemic instability. But somebody in authority should have been asking two questions. First, is the instant destruction of the Cypriot banking system the best way to reform it? Second, what will be the wider implications of this action for the rest of the EU?

One such implication is immediately apparent: the introduction of capital controls, which Cyprus will have to keep in place for who knows how long. Note in passing that, as a result, the euro area is no longer the monetary union it purports to be: A euro in a bank in Cyprus is now worth less than a euro in a bank in France. This violates at least the spirit (and arguably the letter) of the treaty that created the single currency in the first place.

I thought the ECB and its president, Mario Draghi, were going to do whatever it takes to preserve the integrity of the euro system.

Because Cyprus is so small, the cost of a more measured restructuring of its banks would have been modest. Gather the bad assets in a bridge bank capitalized by the European Stability Mechanism with liquidity provided by the ECB until the entity can be wound down. Wipe out shareholders. Haircuts for junior and senior creditors, by all means. Make the help contingent on tax reform, fiscal consolidation and the gradual shrinking of the overseas bank-deposit business. Much of the burden of adjustment would have fallen on Cypriots.

But not all — that approach would have exposed EU taxpayers to a short-term cost. This was deemed unthinkable. Yet there’s a good chance that the bill for the present plan will ultimately be far higher. Possible and even likely outcomes include a future Cypriot sovereign default, and the heightened fragility this would induce in other still-struggling EU economies. Suppose confidence ebbs again in Spain and Italy, bond yields rise and their banks look fragile. Is bailing in uninsured depositors on the menu? It will be interesting to see how small the EU can make its banking sector.

Bailout fatigue says: “The Cypriots got themselves into this mess, and they should get themselves out. We’ll lend them a bit more, but only if we’re sure they’ll pay us back.” Cyprus didn’t get itself into this mess. It joined the euro system in 2008 with low public debt and a clean bill of health from EU governments (back then, not a word was said about shady Russians). Its banks are in trouble not because they accepted too many overseas deposits but because they bought too many Greek bonds — an investment sanctified by international banking rules (which called such investments riskless) that was destroyed by the EU’s ham-fisted resolution of Greece’s threatened default.

Europe’s sense of “we’re all in this together” seems to have evaporated entirely. Now one has to ask not merely what the euro is for, but what the EU itself is for.


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