his article appeared in this month’s edition of The International Economy as part of a feature with seventeen top economists weighing in on Cyprus. Below is the contribution from Institute for New Economic Thinking President Rob Johnson. Be sure to check out the other sixteen here.
Sink or swim? That has long been the Darwinian choice facing each country in the euro zone. And in many ways Cyprus, a small country in the scheme of things, can be seen as just the latest test of Europe’s collective resolve.
Yet the Cyprus fiasco also could prove to be a turning point in the ongoing euro crisis. Once again, just enough has been done to keep a member of the monetary union afloat—but not enough to bring the entire European Union to dry land. And in this case, by pretending they were dealing with an isolated country, the nations of the European Union have damaged the faith in deposit insurance throughout the euro zone. This may become a crippling blow.
The rescue of Cyprus was a microcosm of how the nations of Europe have failed to work together to adequately address their ongoing financial crises. In this case, with Germany unwilling to foot the bill for a loan that it had good reason to suspect would never be paid back, the euro- zone’s finance ministers opted to make the numbers work by going after depositors.
The scheme that taxed even small deposits was eventually abandoned in favor of taxing only those that were uninsured. But the implications to the public were clear. Bank deposits could be at risk in future debt crises. This message was especially significant in Europe, where markets and credit allocation are much more dependent on banking than in the United States.
The so-called “bail in” of depositors (what was called a tax, but was really a haircut in all but name) made the numbers work in the short term. But it has had the long- term effect of undermining confidence in the deposit insurance system across the euro zone, insurance that was one of the only barriers to a full-on banking panic during the early stages of the crisis.
When the next wave of the crisis hits—and eventually it will, as long as Europe continues to rely on half measures to address its problems—depositors across Europe now understand that their leaders have identified a new way to fund the periphery’s debt troubles: their savings.
The anxiety this implicit threat creates may already be contributing to a deflationary shock to Europe’s credit allocation system at a time when the region can least afford it. At a minimum, the Cyprus fiasco has created long-term instability that mere words—the promise that Cyprus will not be a precedent—cannot settle.
Unfortunately, this means that Cyprus is yet another illustration of the collective action deficit at the heart of the euro zone’s struggles. Europe’s countries have not yet learned the lesson that they cannot survive alone.
After Cyprus, the euro zone still faces the same question: sink or swim? And each country in the euro zone is still struggling to stay above water.
Even Germany faces potentially catastrophic economic consequences if the crisis is not resolved. The lessons learned in Cyprus have only made the downward pull of financial gravity a little bit stronger. But the monetary union can’t survive over the long term without collective action.
A true banking union could have helped prevent the fiasco in Cyprus. And it could be the life raft that keeps Europe afloat.
Perhaps it’s time to build that raft. If nothing else, the euro zone countries must find the political will for collective action—or they will each sink alone.
