Cyprus has – or, until last week, had – a lot of banks. It also has a lot of resort hotels. How appropriate that the best encapsulation of its crisis comes from the song, ‘Hotel California.’ What the island country’s near collapse proved is that once you join the Euro, as the Eagles sang, “you can check out, but you can lever leave.” When you have run up an enormous tab, as Greece, Cyprus and other highly indebted countries are beginning to grasp, the costs of leaving the Euro are simply too high ever to depart. In short, the Euro is a prison and the inmates are stuck with each other.
This is why the Cypriot President Nicos Anastasiades capitulated to demands of Europe’s master creditors – the IMF, the European Central Bank, and the European Commission (known as ‘the troika’) – to drastically reduce the size of his country’s number one industry, banking. For the first time in the Euro crisis a debtor country agreed to soak the accounts of high-value depositors to help pay for the bailout. While Anastasiades gamely resisted, the reality is that he had no choice but to accept the troika’s humiliating terms. Otherwise, Cyprus’s banks would have quickly defaulted, taking down the entire banking industry and forcing the state into isolation and a highly uncertain, painful exit from the Euro zone. Even with the bailout, confidence in the Cypriot banking system is so low that the government has had to impose draconian limits on withdrawals from its banks, which will likely last for months.
There is speculation that despite the bailout, Cyprus might yet leave the Euro. However, the time for such a maneuver has passed. Having already accepted the onerous conditions, including profoundly restructuring its two biggest banks, Cyprus has lost the leverage that a threat of an uncoordinated exit would have contained. And that threat, if it ever existed, was hollow. Unlike Argentina, another cash-strapped country that simply unlinked its national currency from the US dollar, allowing the peso to plunge overnight, Cyprus has no national currency. And in order to reintroduce the Cypriot pound, banks would have to prepare for the change-over. But the mere announcement (likely preceded by rumors) of a Euro exit would trigger utter panic, not only a run on the banks but virtually a complete freeze in the private economy as contracts between buyers and sellers would collapse. (Sellers would demand payment Euros and buyers would try to pay in lower value new pounds.)
Clearly, Cyprus has been already the first test of what may happen in the case of a crisis in the financial sector of a Eurozone member. Capital flows have to be blocked or restricted. Only, in the case of Cyprus, if the state manages to remain in the Eurozone, this seems a temporarily measure, up to confidence being restored. But if things start to go worse or a real exit materializes, then the capital freeze may be indefinite or subject to conversion in the new currency. The risk of such a scenario is what scares most investors, as losses may be very substantive.
The Cyprus crisis will have a powerful impact on other indebted Euro zone countries, particularly Greece, which is virtually a sister state. Effectively, Cyprus has thwarted the gambit of the radical left to threaten chaos on the entire Euro area by exiting the currency. Such a threat is no longer – if it ever was -- credible. Athens, which has already endured severe austerity and will soon need to again restructure its debts, will be forced to accept the terms that it is offered.
It is now clear that the endgame of financial crisis in Europe is not a game of chicken with debtor nations that threaten to leave the Euro, but rather a contentious (but one-sided) debate over how much local bank depositors will have to share in the cost of future bailouts. Germany, which is the still the most influential player behind the troika, has again proven its mettle, empowering the troika to risk a systemic crisis (a potential run on bank deposits in the EU) in order to enforce strict conditionality as the price for bank rescue.
The only question now is how far ‘Teutonic toughness’ will go. The cost to Germany is the continued risk that the austerity medicine will prove fatal to one of the indebted patients. Italy’s growing borrowing spreads are a reminder that systemic failure is still possible. Indeed, in the Euro’s ‘Hotel California’, where no country can leave the Euro zone, theoretically there should be no spreads at all. The fact that there are suggests that bond holders still doubt the ability of Euro debtors to pay – and the troika’s willingness (or, in Italy’s case, ability) to come to the rescue.
After elections in September, Germany will have to decide whether it wants to preside over an austere but withered, embittered and unstable southern Euro zone, or accept the responsibility of leading the EU into a new, fiscal compact that finally addresses the root cause of instability. In practice, this means forging a near-term path to fiscal union within the EU, including a sharing of sovereign debt. Penurious Germans, however, recoil from underwriting the profligacy of the Mediterranean debtors and Ireland.
Until Berlin develops a broader vision and finds the confidence to lead Europe to a fundamentally new financial architecture -- the way the United States did at at Breton Woods in the wake of World War II – the Euro crisis will continue. After all, ‘you can check out, but you can never leave.’