Lessons from the Cyprus Bailout

May 1, 2013

Following the Cypriot financial crisis, the International Monetary Fund and European Union designed a bailout package for Cyprus that required the small island nation to reduce the size of its overleveraged banking industry, the size of which was several times the country's gross domestic product. If the Cypriot economy tanks in the near future, as is expected, there are several lessons for Cyprus and for the European Union to take away, says Desmond Lachman, a resident scholar at the American Enterprise Institute.

  • Because its baking- and tourism-based economy was dissimilar from the rest of the European economy, Cyprus should realize that joining the euro was a mistake that will now lead to an expected economic contraction of more than 25 percent over the next year.
  • Cyprus should also realize that the Cypriot banking system should never have been allowed to expand to seven times the size of the economy or to buy Greek government bonds at a time when Greece was struggling.
  • Cyprus should never have proposed a tax on small insured bank deposits, but should have used its financial crisis as an excuse to leave the euro.

For Cyprus, membership in the European Union means that the bailout package will require budget cutting measures at the same time the entire economy is being restructured, which will lower the tourism and export sectors. For the rest of Europe, euro countries should now realize that the euro currency should have been reserved for core countries only.

  • In addition, the European Union should not have agreed to the tax on small depositors, which sent a bad signal to member countries' citizens who now fear the sanctity of their bank accounts.
  • Because the bailout package is likely to lead to the collapse of the Cypriot economy, the European Union should have encouraged the country to exit the euro.
  • The bailout package sets a dangerous precedent of writing down large deposits by around 60 percent, which if used as the model for other bailouts as has been suggested, could be a costly mistake.

Another lesson from the Cyprus bailout package is that German Chancellor Angela Merkel's ability to deal with the euro zone debt crisis has been reduced due to internal German politics.

Source: Desmond Lachman, "10 Lessons from Cyprus," The American, April 25, 2013.

 

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