When the concept of a central currency was introduced to the European Union, EU leaders had an optimistic outlook and disregarded the potential risks. The initial results were positive. Investor confidence in the member nation economies increased as they started attaching the security associated with German bonds to all other bonds of the Eurozone nations. Germany’s low interest rates became associated with the bonds of other member nations. Smaller countries with weaker economies, such as Greece and Ireland, were able to borrow money freely. With their economies doing well, none of the countries suspected anything to go wrong. Smaller countries increased their debts through new government entitlement programs and unnecessary expenditures, which they could not feasibly pay back.
This cheap borrowing fueled a housing bubble, which burst in 2008. Countries with large sectors of their economies dependent on the real estate market, such as Spain and Ireland, saw their revenues plummet, and their governments incurred huge losses and debts. When Greece’s government shifted in 2009 and hidden debts surfaced, investor confidence dropped and the flow of money into Greece greatly decreased. This propagated the economic collapse of these countries, and the costs of saving their economies steadily rose.
What happened with Cyprus?
Initially, Cyprus had a healthy economy, where the government had a budget surplus, the banking system was functional, and investments were pouring into the country. Yet, when Demetris Christofias, a member of the Communist party, was elected president in 2008, there was a shift in policies. With a healthy economy to support them, the government started spending more money and promising new government programs for Cypriots. These risky expenditures led to a decrease in capital inflow and foreign investors became wary of the new government policies.
The EU meeting in October 2011 strategized to solve Greece’s debt problems by wiping out nearly 80% of their debt held by the public sector. Cypriot banks were holding a lot of Greek debt, and incurred losses of approximately 5 billion dollars. With these losses and their loss of the international capital markets, Cypriot banks found it nearly impossible to meet the 9% capital requirements that were enacted by EU leaders.
Cyprus leaders decided it was time to look outwards for aid. The International Monetary Fund imposed terms for Cyprus to receive a 1 billion Euro bail out. IMF managing director Christine Lagarde supports austerity measures while ensuring “the poorest Cypriots would be protected from the worst of the cuts.” As a result, Cyprus imposed a one-off 9.99% tax on deposits greater than 100,000 Euros. Other austerity measures such as public sector cuts and tax increases “are estimated to save around 5% of GDP.”
What this means for the Eurozone
Cyprus is a model for what happens when a government values reelection over market security. Because of their unwillingness to restructure their financial markets, Cyprus will now have to enact politically unfavorable austerity measures to save their economy and debts. The one-off deposit taxes are punishment imposed by the IMF and ECB onto Cyprus for its risky financial endeavors. Yet, most of the fees will not target the real perpetrators of the crisis. The Telegraph of April 29, 2013 notes, “Here, it’s not oligarchs but middle-class entrepreneurs who have been devastated by the crisis.” The wealthiest, such as the Russian oligarchs, have intricate monetary distribution and thus only kept a small portion of their money in Cyprus banks and were not as greatly affected.
The IMF also asks for Cyprus to cut their social welfare programs and increase their low corporate income tax, both measures which in the long run will allow for a budget surplus, but in the short run, hurt both their citizens and foreign investors. One investment banker asked, “Why should I leave my money in Cyprus?” With the debt being placed onto bank depositors, it’s most likely that less people would want to place their money into Cyprus banks, mainly because they are worried that another bailout and deposit tax will happen again.
While being a part of the Eurozone allows for benefits such as easier transaction flows and financial security for smaller countries, these advantages also lead to irresponsible lending practices as seen by the current crisis. Smaller countries believe that larger countries will bail them out as needed, which is true as demonstrated by Germany’s bail out package to Cyprus. Possessing this mentality of financial security is useful to a certain extent—making risky investments is the way an institution can invest in new innovations and make unexpected returns. Yet, there has to be a limit at some point. Having a centralized currency reduces the flexibility each individual country has in solving their fiscal crisis. Because individual governments can no longer alter the value of their currency, imposing wage reduction measures in order to save employment and devaluating currency to encourage exports were no longer possible. Governments have to turn to unfavorable austerity measures, while hoping for bailouts from the International Monetary Fund and EU. What the EU needs the most now is solidarity to weather the crisis and institutional memory to ensure that another Cyprus or Greece doesn’t happen again.