Does Europe’s Cyprus experiment stand a chance?


German Chancellor Angela Merkel speaks to the forerunner of Cyprus' presidential race and president of the right-wing Democratic Rally party Nicos Anastasiades (R) upon her arrival at a European People's Party (EPP) summit in the Cypriot town of Limassol January 11, 2013.

Article Highlights

  • Macro-economists must welcome the way the European Union is handling Cyrpus’ current economic & financial crisis.

    Tweet This

  • The basic source of the economic & financial crisis in Cyprus was an out-of-control banking sector.

    Tweet This

  • Cyprus is not being allowed by the European Union or the ECB to go down Iceland's successful path to crisis resolution.

    Tweet This

A basic weakness of macroeconomics as a discipline is that one cannot conduct controlled experiments as is routinely done in the physical sciences. For this reason, macro-economists must welcome the way in which the European Union is handling Cyprus' current economic and financial crisis. Since, while the Cypriot crisis bears a strong resemblance to that of Iceland in 2008-2009, it could not be being dealt with in a more different way. The results of this experiment should prove invaluable in clarifying which policies work best in crisis resolution.

Iceland Round Two?

Aside from sharing the common feature of being small open island-economies, Cyprus and Iceland had very similar origins to their economic and financial crises. In both countries, rather than profligate public finances, the basic source of the crisis was to be traced to the respective countries having allowed their banking sectors to get out of control. In the case of Iceland, the banking sector was allowed to increase to more than 10 times the size of the Icelandic economy with an important contribution from British and Dutch deposit inflows. In Cyprus the banking sector increased to 8 ½ times of the economy with an important contribution from Russian money laundering.

A further basic similarity between Iceland and Cyprus was how irresponsibly each country's banking sector loaned money. In both countries, an excessive amount of credit was directed at the domestic real estate market, which in each case resulted in meaningful domestic real estate bubbles. Similarly, in both countries the banks made highly imprudent overseas investments that were to cause great loan losses and that were to threaten both countries' public finances. In the Icelandic case, poor loans were made to finance ill-advised company acquisitions particularly in the United Kingdom, while in Cyprus very poor loans were made to the Greek government and the Greek private sector.

It is in the treatment of their respective crises that fundamental differences between Iceland and Cyprus emerge. In the Icelandic case, a highly heterodox policy approach was applied in large measure in response to popular domestic political pressure. By contrast, in Cyprus the crisis appears to be being handled strictly according to the rigid European and ECB playbook. And Cyprus is complying for fear of risking being ejected from the Euro.

There Is a Solution

Iceland's heterodox approach to its crisis rested on three pillars. The first was to allow the currency to float, which involved an approximate halving in the value of the Icelandic currency. This was done to provide a boost to exports as an offset to the large amount of budget tightening that was required to repair the damage to the public finances from the financial crisis. The second pillar was to put domestic retail depositors ahead of foreign bond-holders in exercising claims on the domestic banking system. This forced foreign bondholders to share in the support of the financial system's rescue. And the third pillar was to impose far-reaching capital controls with the explicit purpose of locking in offshore holders of the Icelandic currency in order to reduce downward pressure on the currency.

Heterodox and controversial as the Icelandic adjustment program might have been, it has to be judged to have been relatively successful, especially if compared to the adjustment programs in Greece and Latvia. Whereas both Greece and Latvia experienced cumulative output declines of around 25 percent, Iceland's output loss was limited to 8 percent before a moderate economic recovery got underway in 2011. And despite the very large currency depreciation, Iceland's inflation has been kept at a modest level and order has been restored to its public finances.

The Forced Austerity Alternative

Despite Iceland's relative success, Cyprus is not being allowed by the European Union or the ECB to go down Iceland's path to crisis resolution. In particular, being a member of the European Monetary Union, Cyprus is being precluded from using either currency devaluation or capital controls to strengthen its external sector. In addition, for fear of demonstrating that the Greek case of large debt write downs was not a special one-off case, Cyprus is not being allowed to entertain the idea of either sovereign debt reduction or of a bail-in of its bank creditors. And this is the case despite the IMF's strictures that the cost of bailing out Cyprus' banks will exceed 55 percent of GDP, which will render Cyprus' public debt unsustainable.

Instead, Cyprus is being required to address its financial imbalances by severe budget austerity and structural reform. In particular, it is being required to reduce its budget deficit by around 7 ¼ percent of GDP over the next three years, of which as much as 3 percentage points of GDP is to be done in 2013. In the context, of Cyprus' banking sector problems and its ongoing real estate bust, one has to fear that, as was the case in Greece before it, this degree of fiscal tightening will result in a steeper decline in Cyprus' GDP than the 3 percent decline being anticipated by the IMF and the EU for 2013. Should that occur, Cyprus might too learn that excessive budget austerity can prove to be counterproductive in restoring balance to a country's public finances.

From a humanitarian point of view, one has to be dismayed that Cyprus is being led down a path that will exert much pain but that is unlikely to in the end forestall a large write down in its government debt. However, from a macro-economist's vantage point one must welcome the fact that Europe will be offering one the experiment of such different policy approaches for two countries whose economic and financial difficulties shared so much in common.

Also Visit
AEIdeas Blog The American Magazine
About the Author


  • 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
  • Assistant Info

    Name: Emma Bennett
    Phone: 202.862.5862

What's new on AEI

image Dad and the diploma: The difference fathers make for college graduation
image A better way to finance that college degree
image Fracking for bigger budgets
image Earth Day: Hail fossil fuels, energy of the future
AEI on Facebook
Events Calendar
  • 21
  • 22
  • 23
  • 24
  • 25
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.