CyprusProtester.jpg.jpg
Protesters outside the Cypriot parliament voice their disgust with the original bailout (Reuters)

What if doing the right thing in Cyprus bankrupts Cyprus?

That's not so much a "what if" as a "what is". The finally agreed to Cypriot bailout and bail-in will save the Cypriot financial system by destroying it, along with the rest of their economy. In other words, Cyprus has traded default for depression, instead of devaluation. But this depression -- and it will be a capital-d "Depression" -- will make staying in the euro a political and economic nightmare. The sooner Cyprus wakes from it and abandons the common currency, the better. 

The tiny island has become the epicenter of the latest round of euro-angst after its too-big-to-save banks got in need of saving. Those banks had inflated to seven times the size of the €18 billion ($23 billion) Cypriot economy due to massive inflows of (sometimes illicit) offshore money, mostly from Russia, looking to dodge taxes back home. Now, there are plenty of tax havens around the world, but none of the others made the balance-sheet-destroying mistake of investing in Greece. That left Cypriot banks woefully undercapitalized. And the Cypriot government was woefully unable to fill their capital holes.

That's when the tragicomedy of errors began. Cyprus, Russia, and the so-called Troika of the European Commission, European Central Bank, and the International Monetary Fund, entered into a potentially high-stakes game of chicken over who would pay for the island's insolvent banks. First, Cyprus rejected the Troika's plan to wind down its two biggest and most troubled banks; then rejected the Troika's backup plan to tax insured and uninsured bank deposits; then got rejected by Russia in its bid for a Hail Mary loan; and then, finally, under pressure from the ECB, agreed to ... wind down its two biggest and most troubled banks. In other words, it was a productive week, if their goal was to achieve nothing other than destroying all confidence in their economy.

Thanks for the Bailout ...
Not that much confidence is justified. The ultimate deal in Cyprus was right on the merits, but those merits will leave its economy in ruins. Cyprus got €10 billion ($12.8 billion) from the Troika to bail out its government, and, in return, agreed to "bail-in" bank creditors to pay for its bank rescues. Here's how the bail-in is going to work.

-- Laiki Bank, Cyprus' second-biggest, will be shut down, and split into a good and bad bank. The good bank will get all insured deposits of €100,000 ($128,000) or less, and €9 billion ($11.5 billion) of assets used to get "emergency liquidity assistance" (ELA) loans. The bad bank will be capitalized by wiping out shareholders, bondholders, and uninsured depositors. The latter will recover whatever money the bad bank gets from selling off its toxic assets -- but that's not expected to be much. Cypriot officials estimate uninsured depositors at Laiki could face losses of up to 80 percent.

-- The Laiki good bank will be merged with the bigger, and just as insolvent, Bank of Cyprus. This new mega-bank will be recapitalized by, again, wiping out shareholders, bondholders, and uninsured depositors. The latter will, again, recover whatever money isn't needed to get the new bank to a 9 percent capital ratio. Officials expect these uninsured depositors could face losses of 40 percent.

-- Cyprus will put in place "temporary" capital controls to prevent depositors from pulling their money out of the country en masse. In other words, a euro in Cyprus is stuck in Cyprus. Or at least that's what the authorities hope. Among other things, people won't be allowed to cash checks, close out term deposits before maturity, take more than €300 ($384) out from each bank a day, take more than €1,000 ($3,440) of the country for trips, buy more than €5,000 ($6,400) with credit or debit cards abroad, or send more than €5,000 to overseas students each term. These restrictions are only supposed to last a week, but they could easily go until May -- if not much longer. (As Hugo Dixon asks, how many academic terms are there going to be in the next seven days?). Indeed, Iceland introduced its own supposedly short-lived capital controls back in 2008, and still hasn't lifted them.

... Now Here Comes the Depression
This was the right thing done at the wrong time. In principle, bank creditors should pay for bank rescues (if done the right way). And offshore tax havens should get, euphemistically-speaking, "reformed". But doing so now leaves Cyprus with very little hope for any kind of future. It's just been hit by three mega-shocks: fiscal, financial, and wealth. For one, its age of austerity is just about to get more austere, as the Troika demands further tax hikes and spending cuts in return for its €10 billion bailout loan. For another, its bail-in and capital controls will effectively kill off its financial sector -- which now makes up 18 percent of its GDP -- and starve its people and businesses of credit. Even worse, those people and businesses are going to need credit now more than ever after losing so much of their wealth in the bail-in.

In other words, Cyprus is about to collapse.

It's not clear just how great this depression will be, but the early estimates are, well, depressing. As you can see below, the International Institute of Finance thinks Cypriot real GDP could fall as much as 20 percent over the next few years. The difference between the green and red lines shows just how destructive the last week has been for Cyprus.

CyprusGDP.png

And remember, unemployment is already 14.7 percent in Cyprus. It could easily climb to 25 percent, or worse, depending on how many people flee the island for expatriate life. 

Revenge of Stein's Law?
This kind of prolonged slump is politically unsustainable. And, as economist Herbert Stein pointed out, unsustainable things have a way of, well, not being sustained. Indeed, unlike the rest of Europe's troubled economies, the euro isn't terribly popular in Cyprus right now. Only 48 percent of Cypriots were in favor of the common currency last November, as you can see on page 69 of this Eurobarometer survey, compared to 67 percent of Irish, 65 percent of Greeks, 63 percent of Spaniards, and 57 percent of Italians. The euro is actually less popular in Cyprus than anywhere else in the euro zone -- and it's only going to get less so as their economy disintegrates. There's going to be quite a market for Euro-skeptic parties.

But the question now isn't whether Cyprus should keep the euro. It's whether Cyprus should leave the euro. Those aren't the same thing anymore. As Tyler Cowen points out, a euro that can't leave Cyprus is worth less than other euros. Just how much less depends on how strictly Cyprus prevents euros from leaving the country. In other words, as long as it has capital controls, Cyprus doesn't really use the euro anymore even though its money says "euro" on it. It uses Cypriot euros. And Cypriot euros are worth maybe 95 or 90 or 80 percent, or less, of other euros.

Cyprus is stuck in euro-limbo. It's not enjoying the benefits of the common currency, but it's not enjoying the benefits of its own currency either. Not that bringing back its own currency makes sense, right? As Barry Eichengreen points out, countries can't leave the euro because its banks would collapse and there would be massive capital flight, and ... wait. These things have already happened in Cyprus. Its banks just got restructured, and it just instituted capital controls. There's not much left to lose from euro-exit. And plenty to gain.

Cyprus needs to cut its uncompetitively high wages. It can either make people take pay cuts or make its currency worth less. Well, if it's in the euro it has one option: force people's wages down. But people don't like to take pay cuts. (Yes, economists have studied this, and even have a term for it: "downward nominal rigidity"). It's perfectly rational. Debts don't go down even if wages do, which means lower wages make debts harder to pay off. And, of course, nobody wants to be the first (and maybe only?) one to take a pay cut. This kind of "internal devaluation" typically takes a looong time. 

But if Cyprus abandoned the euro, as Paul Krugman argues it should, it could reduce the value of its currency, instead of its wages. That would trade years of grinding deflation for immediate devaluation -- without increasing domestically-denominated debt burdens. This latter point doesn't apply to most of Cyprus' sovereign debt, which is under foreign law and can't easily be redenominated, but that's not a real concern. As Krugman points out, its sovereign debt burden will grow regardless -- deflation and depression will destroy the denominator of its debt-to-GDP ratio.

To be clear: devaluation wouldn't prevent the coming collapse in Cyprus. It would just allow for a quicker recovery. Instead of one-by-one trying to force people to take pay cuts for years, it would force everyone to take a pay cut overnight. Inflation would soar, along with the cost of essential imports like food and energy, but that's a cost worth paying for the chance to grow again. Cyprus won't have that chance for quite awhile if it stays in the euro.

Default is just another word for nothing left to lose. The question now is how much Cyprus has left. Not much, it seems. Its banks are dead, its real economy is about to go into deep depression, and its people are particularly ambivalent about the common currency. It's not hard to imagine these facts adding up to euro-exit at some point in the future. The faster that future arrives, the better.

Cyprus has nothing to lose, but too tight money.