The troika plan presented to Cyprus would ruin the economy, and start a run on banks that may spread elsewhere
Cyprus is a small island economy with a hugely oversized banking system, and is thus similar to both Iceland and Ireland. Banks in Iceland speculated on derivatives; Irish banks gambled in real estate; Cypriot banks made large loans to the Greek government and Greek businesses. In all three, banks failed systemically and threatened the whole of the economy.
Still, Cyprus banks are small beer and did not pose a risk to international finance by themselves. The danger has arisen because of the troika of the EU, the ECB and the IMF. For a start, Cypriot banks have failed mostly because of troika policies. The troika obliged the Greek state to apply a haircut to its bonds in 2012. Troika policies also forced the Greek economy into depression in 2010-12, making it impossible for businesses and households to repay their debts.
When banks fail in a systemic way, the policy options are few. Ireland followed a certain path, determined by the troika and membership of the EMU. It supported its banks by using public funds, and protected large bondholders, who were other European banks. Irish public debt rose and the country faced austerity, privatisation and liberalisation. The result was a long-drawn out recession, falling incomes, and persistent unemployment. In effect, the costs of failed banks were brazenly shifted onto society as a whole.
Iceland followed a radically different path, as it is free of the troika and not a member of the EMU. It refused to increase its national debt and it thus let banks go bankrupt, shifting the costs on to shareholders, bondholders and depositors abroad. Iceland looked after small depositors, but also allowed its currency to devalue and applied capital controls. The country avoided a deep and protracted recession, and last year the economy grew at 2.5%.
The deal currently offered to Cyprus by the troika is along the path of Ireland – except much worse. Cypriot banks need €17bn; the troika is proposing that the Cypriot state should increase its borrowing by €10bn and that the rest should be obtained mostly by imposing a levy on deposits. This is a terrible plan.
The extra borrowing will raise Cypriot public debt well over 100% of GDP. The economy is already in recession and, with the extra austerity measures, including the inevitable blow to bank credit, contraction might be around 5% this year. It is likely that the increased national debt will need restructuring in the near future, meaning fresh loans and even more austerity.
The worst aspect of the plan, however, is the levy on deposits. In part, it is morally offensive as small depositors are merely savers who also use the money services of the banks. Why should they be charged for failed bank loans? But much worse is the plan's recklessness. Banks engage in a confidence trick: depositors must believe that their money is safe because, if they did not, they would rush to withdraw it and banks would go bankrupt. To harm the confidence of depositors is to invite a bank run, which might be panicky, as in the case of Northern Rock, or silent, if large depositors simply left.
As things stand, it is almost certain that there will be a bank run in Cyprus when the banks reopen, and hence the government has declared a bank holiday. The repercussions in Greece, where Cypriot banks also have large deposits, and in other countries of the eurozone can only be guessed. What is beyond dispute is that a precedent has been created in the EMU and depositors in peripheral countries with weak banks will take note. Bank runs can run for several days and panic can spread.
The troika proposed these measures because it did not wish to rescue large Russian depositors, some with shady backgrounds. This is certainly laudable, but the cure is worse than the disease. The plan will ruin the Cypriot economy, while delivering an extraordinary shock to confidence in European banks.
Cyprus now has a very tough decision to take. It is clear that it can expect no real solidarity from the EU, while being subjected to unfair rules that do not apply to anyone else. If it submitted to the plan, it would be entering a long and dark tunnel. But it could also reject it, seeking a different path. Above all, it must not be bullied by the fear of exiting the EMU. The country has other options, including shifting its international alliances. If it chose to reject the plan, the experience of Iceland would stand it in good stead. The arrogant and blinkered establishment of the EMU might at last take notice.
• Costas Lapavitsas wrote this article before the latest events in Cyprus, where MPs have rejected the bailout terms
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