Europe could have dealt with Cyprus cheaply and painlessly with a pan-European body able to recapitalising the country's banks
It had all started to look quite promising. The US was picking up, China had avoided a hard landing and in Japan the early signs from the new government's anti-deflation approach were encouraging. Even in Britain, the first couple of months of 2013 provided some tentative hope – from the housing market and consumer spending, mainly – that the economy might escape another year of stagnation.
Then Cyprus came along. The last two weeks of March brought the crisis in the eurozone back into the spotlight, and by the end of the month the story was no longer rising share prices on Wall Street on the back of strong corporate profitability or the better prospects for Japanese growth. It was, simply, which country in the eurozone will be the next to require a bailout.
The past few days has seen what Nick Parsons, the head of strategy at National Australia Bank, has called the "reverse Spartacus" effect after the scene at the end of Stanley Kubrick's epic in which captured slaves are offered clemency if they identify the rebel leader. All refuse.
In the aftermath of Cyprus, it has been a case of "I'm not Spartacus". Four members of the eurozone felt the need to issue statements explaining why they were different from the troubled island in the eastern Med. We now know that Portugal is not Spartacus, and neither is Greece, Malta, or Luxembourg, which has a higher ratio of bank deposits to GDP than any other eurozone country. As Parsons noted wryly, Italy was unable to say it was not Spartacus because it still doesn't have a government to speak on its behalf. Otherwise it would probably have done so.
Few of the independent voices in the financial markets take such attempts at reassurance seriously. Another crisis in the eurozone could be avoided, but only if those in charge (sic) act more speedily and effectively than they have in the past. As things stand, another outbreak of trouble looks inevitable.
Cyprus has enough money to get by for a couple of months, but by then will be feeling the impact of a slow-motion bank run as depositors remove their money at the rate of €300 (£250) a day. The economy has been crippled by the terms of the bailout, a Carthaginian peace if ever there was one, and the country's debt ratio is bound to explode.
Investors are already casting a wary eye over Malta, which appears to have been the short-term beneficiary of capital flight from Cyprus, but the bookies favourite for the next country to need a bailout is Slovenia, where the government is already making contingency plans for coping with bank losses.
By focusing on the eurozone's minnows, the markets are in danger of overlooking a much bigger potential problem. If attempts to put together a new government in Rome fail, Italy will be facing a second general election and in such a scenario opinion polls currently put Silvio Berlusconi ahead.
It is not hard to sketch out a sequence of events in which Berlusconi completes a political comeback, the markets take fright, Italian bond yields go through the roof, the European Central Bank under Mario Draghi says it will only buy Italian debt if Berlusconi agrees to a package of austerity and structural reforms, the new government refuses and then calls a referendum on Italy's membership of the single currency. Italy has already had six consecutive quarters of falling GDP and is on course for a seventh, making the recession the longest since modern records began in 1960. So when Berlusconi says he cannot let the country fall into a "recessive spiral without end", he strikes a chord.
If policymakers are alive to the threat posed by one of the six founder members of the European Economic Community back in 1957, they have yet to show it. The assumptions seem to be that Cyprus is exceptional, that the ECB will ride to the rescue if it proves not to be, and that Europe will be dragged out of the danger zone by the pickup in the rest of the global economy.
This is the height of foolishness. The factors causing the crisis in Cyprus are replicated in many other member states. The ECB's so-called "big bazooka" has yet to be tested, and because Europe is the world's biggest market, the likelihood is that the re-emergence of the sovereign debt crisis will seriously impair growth prospects in North America and Asia.
Economists at Fathom Consulting draw a comparison between the eurozone today and the UK at the very start of the financial crisis. Mistakes were made with the handling of Northern Rock because of fears that a bailout would create problems of moral hazard – in other words helping a bank that had got itself into trouble through its own stupidity would encourage bad behaviour by others. The systemic risks were not recognised, with disastrous consequences.
Similarly, Fathom argues, the eurozone has not understood the systemic potential of the current crisis, not least the "doom loop" between fragile banks and indebted governments. Austerity is making matters worse because cuts to public spending and higher taxes hit economic activity by more than they reduce government deficits. Public debt as a share of national incomes goes up, not down.
Austerity can work, but the conditions have to be right for it. It helps if a country's trading partners are growing robustly, because then the squeeze on domestic demand can be offset by rising exports. It helps if the central bank can compensate for tighter fiscal policy by easing monetary policy, either through lower interest rates or through unconventional measures such as quantitative easing. And it helps if the exchange rate can fall. Not one of these conditions applies in the eurozone, which is why the fiscal multipliers – the impact of tax and spending policies on growth – are so high. Put bluntly, removing one euro of demand through austerity leads to the loss of more than one euro in GDP.
So what should be done? Clearly, the self-defeating nature of current policy needs to be recognised. Countries need to be given more time to put their public finances in order. The emphasis should be shifted from headline budget deficits to structural deficits so that account is taken of the state of the economic cycle, and the ECB needs to be ready with its own version of QE.
Simultaneously, work needs to speed up on creating a banking and fiscal union. Europe could have dealt with Cyprus cheaply and painlessly had there been a pan-European body capable of recapitalising the country's banks. Delay in setting up such a body threatens to be costly.
Finally, the eurozone needs to start talking with one voice. A bit of "I'm Spartacus" would not go amiss.
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