Ignoring Cyprus would be a mistake

Prussian Chancellor Otto von Bismarck may have been right to worry that “some damned fool thing in the Balkans” might trigger a Europewide war, but could some busted banks in Cyprus really trigger a global financial crisis?

Or, to paraphrase pre-World War II British Prime Minister Neville Chamberlain: Why should “a quarrel in a far-away country between people of whom we know nothing” hurt our pocketbooks in the U.S.?

The answer is that we don’t know for sure, but we may find out. History, after all, was not kind to the dismissive statements of Bismarck and Chamberlain.

Cyprus certainly is small. Its population is about a third of the Twin Cities metro area, and its area is about half that size. Its economy makes up less than 1 percent of the 27-nation European Union.

How could its banks be busted to the tune of $22 billion dollars, about $20,000 for every man woman and child on the island? And how in the world did it develop a banking sector with deposits six times as large as its gross domestic product when comparable deposits in the U.S. are only about two-thirds of our gross domestic product?

The answer is a cautionary tale about the dangers of interconnectedness — and hence vulnerability — of global finance and poorly regulated financial institutions.

The major banks on Cyprus are bankrupt. Banks take in deposits, then loan or invest the money. Banks go bust when so many loans or investments go bad that they cannot repay their depositors.

In this case, the exact makeup of what went bad is not clear.

Some money was invested in Greek government bonds. When that government got into trouble, the terms of the bailout from the eurozone and the International Monetary Fund, or IMF, required a partial write-down of the bonds’ principal. As a result, the banks and the government of Cyprus now cast themselves as victims of the actions of others.

This conveniently ignores the fact that if the Greek bailout had not occurred, these bonds would be near worthless. Moreover, the Cypriot economy, which still is closely tied to Greece, would have been thrown into deep recession if Greece had collapsed. So don’t cry too many tears for the nation of Cyprus as an innocent victim.

But Cypriots with small bank deposits deserve more compassion than bank and government officials. People in a small nation seldom have as many opportunities for saving, such as mutual funds or liquid stock and bond markets, as do those in large countries. Savings accounts in local banks were the only practical option.

Ordinary citizens had no real control over the fact that their savings were in the same bloated and poorly managed banks that held the funds of shady Eastern European government officials and oligarchs. Even though Cyprus is a democracy, successive governments encouraged turning the island into a “fiscal paradise” that lived off sheltering money from Russia, Ukraine and other nations.

Thus they do have some right to feel aggrieved. But it’s clear that there were benefits to acting as the money-launderer and bolt-hole of choice for some wheeler-dealers from the former Soviet Union. Few objected to their nation’s new international role as long as it meant booming business and plenty of jobs.

One genuine beef for small depositors is that the proposed bailout by the European Central Bank and IMF included a “tax” on depositors. The country’s Parliament voted that down on Tuesday.

This tax seemed unjust. Many worried that a precedent for a eurozone tax on savings was being set. But consider: Without a bailout, the Greek bonds held by the Cypriot banks would have reduced the funds generally available to depositors by much more than this tax.

Fortunately, Cyprus does have deposit insurance covering all accounts up to 100,000 euros — ostensibly protecting small depositors from any Greek default. If the banks actually went bust and if the government deposit insurance plan had the funds to cover any losses, none of the small depositors would lose anything. Unfortunately, Cyprus’s government does not have the money to make good on its promise.

Feared precedents of a Europewide savings grab aside, this de facto breach of a legal guarantee for small deposits is the most likely way that events in Cyprus could affect the rest of the eurozone and hence the rest of the world. It sets a precedent that legal guarantees can be overridden at the will of the most politically and economically powerful nations in Europe.

Small depositors in Spain, Portugal, Italy, Ireland, France and elsewhere are covered by the same 100,000 euro insurance.

If it is shown to be untrustworthy, they might rush to withdraw their funds.

For already shaky banks in many countries, such a classic “bank run” could be catastrophic. If these banks collapsed, problems could spread to otherwise sound institutions, touching off a deep European financial crisis.

Global finance is so interwoven that it would be hard to stop a severe European financial crisis from becoming a global one.

But we are in uncharted waters, no one really knows what will happen or how harsh or how mild any repercussions will be.

Much more could be said about the political interactions involved, including lingering resentments about the way Greece blackmailed the rest of the European Union into accepting Cyprus as a member in 2004 or the reluctance of the German and Dutch governments to act in ways that appear to be bailing out corrupt Russian businessmen and public officials.

And, once again, German banks reportedly would suffer some billions of euros in losses if the Cypriot banks all collapsed. Suffice it to say that there is no moral high ground in the whole sad affair.

Regardless of how it plays out, there are lessons about the danger of a central bank, such as the ECB, having an obligation to act as a lender of last resort to a banking system over which it has little regulatory power.

And this gets to the core problem of the European common currency: Can the system survive amid such disparate cultures, politics and legal systems. I think not, and any possible road ahead looks bumpy indeed.

For an excellent series of 19 articles, on the Financial Times-Alphaville blog, exploring the whole crisis go to http://ftalphaville.ft.com/tag/a-cypriot-precedent/.