Letter from Cyprus
April 2013
There’s a simple economic equation which goes to the heart of economics: savings equals investment.
An economy can’t grow if there is no investment. That’s obvious. And what do you invest? Money which has been earned but hasn’t been spent on consumer goods. That is, savings. When the public save, they put their savings in a bank. They assume their savings are safe there. Safer than putting cash under the mattress or in a cupboard. The bank then lends that money out. That drives investment.
Imagine what it means to an economy if the government comes along and says it’s going to confiscate some of those savings. Not only are the hard-earned savings stripped away but money which can drive investment is lost.
Well, welcome to modern Cyprus. It wasn’t the government that launched an attack on people’s savings but the troika of the IMF, the European Commission and the European Central Bank.
The Cyprus story is a story of huge bad luck. As a result of the war in 1974, the Cypriot economy declined by around 30 percent in two years. It was a terrible blow. But an industrious and business savvy people rebuilt their lives – the Turkish Cypriots being heavily assisted by Turkey. The Greek Cypriots prospered by promoting their sun-drenched island as a tourist paradise. But they also encouraged banking and finance using two tools: a sound legal system partly inherited from the British and low taxes.
While income taxes in Cyprus are not too dissimilar from the generality of European taxes, company tax is only 10 percent. This formula attracted foreign capital and the trend accelerated after Cyprus joined the European Union in 2004. The banks, as banks do, lent out the deposits and given the affinity between Greek Cypriots and Greece, lent plenty of money to Greek businesses. And what is more, the Cypriot banks bought Greek government bonds.
The global financial crisis and a long history of government profligacy in Greece led to the near collapse of the Greek economy. It had to be bailed out. That had two effects on Cyprus. First, as Greek borrowers went to the wall, so the Cypriot bank loans transformed into bad debts. And secondly, the terms of the Greek bailout meant that Greek government bond holders were told to take a “haircut” – that is to lose half the face value of their bonds.
For two Cypriot banks in particular, this was devastating. For the government in Nicosia, the cost of bailing out the banks was way beyond their means. The troika had to come to the rescue. And apart from a very severe austerity package coupled with a suite of economic reforms, the troika demanded Cypriot depositors contribute to the bailout.
But the issue is a bigger one than little Cyprus. It raises real questions about the management of the eurozone itself.
Here are the dilemmas. The Cypriot bailout will be financed significantly by other countries in the eurozone, above all Germany. This bailout comes on top of the bailouts already costing tens of billions of euros for Ireland, Portugal, Spain and Greece. These bailouts have to be approved by each of the parliaments of the 17 eurozone countries. So on the one hand you have the inevitable anguish and pain from the conditions imposed on the borrowing countries. But on the other, you have taxpayers in the lending countries smarting that they have to finance what many of them see as the financial recklessness of lands far away.
How Australians would squeal if our government had to borrow to survive but only on terms that would cut pensions and public sector wages by, say, 20 percent and impose a restructuring of our social security system denying some beneficiaries their benefits altogether.
But look at it the other way: what would Australians say if New Zealand and Papua New Guinea went broke and our government told us we had to spend $50 billion bailing them out?
It’s quite a dilemma. In the case of the largest lender, Germany, they have an election later this year. So not only does the parliament now have to approve the Cyprus bailout – on top of all the others – but those members of parliament want to get re-elected.
This tragedy in the eurozone should encourage the EU to restructure the euro. If it is to survive as a single currency, then there will have to be much more coordination of EU fiscal and broader economic policy. And government debt in the eurozone will have to be mutualised.
Europe is at a crossroads. Either the EU integrates further and the individual member states surrender a lot more of their sovereignty, or it will atomise and the euro will eventually collapse. The European project will then be at an end. I’m not sure European voters quite want to make either decision. Well, democracy requires that all the people take responsibility for their decisions. In Europe they’re going to have to think very hard about what to do next.
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