10 lessons from Cyprus

Article Highlights

  • Cyprus should have known if its economy got hit, it wouldn’t be supported by fiscal transfers from EU interest rates.

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  • The Cypriot government’s proposal to impose a 6.75 % tax on small insured bank deposits was a huge economic blunder.

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  • It would have been better if Cyprus had exited the euro as opposed to undergoing a bailout program that will fail.

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By destroying Cyprus's bank-centric business model and by imposing severe austerity on the country within a euro straitjacket, the International Monetary Fund-European Union bailout package for Cyprus is likely to lead to the literal collapse of the Cypriot economy over the next year and to Cyprus's exit from the euro. Such a course of events will have important ramifications for the rest of the European Monetary Union. When the dust settles and future historians seek to draw lessons from Cyprus's sorry experience in the euro, they will likely draw the following conclusions.

Lessons for Cyprus

1. Joining the euro was a tragic mistake.

Before joining the euro, Cyprus should have considered that its banking- and tourism-based economy had nothing in common with the rest of the European economy. It should also have recognized that if its economy got hit by a major negative external shock, Cyprus would not be supported by fiscal transfers from the European Union or by lower European Central Bank (ECB) interest rates. Cyprus is now paying a very high price for this mistake, as its economy is likely to contract by at least 25 percent over the next year.

2. Allowing unregulated banks to grow so large was a blunder.

It is bad enough that light regulation of the Cypriot banking system allowed that system to grow to more than seven times the size of the Cypriot economy, mainly due to large Russian deposit inflows. However, it is unconscionable that the bank regulators allowed Cypriot banks to buy Greek government bonds amounting to 150 percent of the size of Cyprus's GDP. This combination was an accident waiting to happen - and it did happen when the Greek government defaulted on its bonds in 2012. The net result was bank losses close to €10 billion, or 60 percent of Cyprus's GDP.

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About the Author

 

Desmond
Lachman
  • Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.
  • Phone: 202-862-5844
    Email: dlachman@aei.org
  • Assistant Info

    Name: Emma Bennett
    Phone: 202.862.5862
    Email: emma.bennett@aei.org

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