Why a ‘small’ bailout for little Cyprus is a big deal

The bailout of Cyprus is garnering much less attention than did the help provided to other struggling euro zone members.

Cyprus is tiny, and rescue or no rescue, the euro will remain largely unaffected. Or so the argument goes. While those who scoff that Cyprus’ request for €17 billion ($23 billion) is chump change compared to the Greek and Spanish bailouts and the hordes of bailout-ready cash stashed at the European Stability Mechanism (ESM), they are wrong to ignore the power of the precedent that Cyprus presents to the euro zone.

We’ve heard the “small” argument before. Before the Greek bailout gathered momentum in 2010, pundits, economists and politicians claimed that Greece posed no threat to the stability of the euro because it accounted for only 3 percent of the euro zone economy. So what changed their minds to grant Greece its 2010 bailout and two others since then?

Greece didn’t get any bigger relative to the rest of Europe. In fact, it now represents 2.5 percent of total euro zone GDP. Instead, the “small” argument quickly lost merit in explaining the significance of the Greek crisis. Events don’t occur in a vacuum. And it was that realization that changed their minds.

The worry was that if Europe were to have let Greece go, the effects would have caused a much larger problem for the stability of the common currency.

Europe’s economic woes are not isolated to Greece and the euro zone’s creditors know this. That’s why Spain and Italy have had several uncomfortable run-ins with high bond yields, and now France is coming into the crosshairs of the international financial community as its lack of competitiveness — and the lack of political will to do much about it — has sparked rumors of another credit downgrade.

Greece set an important precedent for creditor security, as letting it default would have led investors to question the security on their investments in other euro zone countries with deeply rooted economic problems. If the European Union wouldn’t rescue Greece, then who would it rescue?

The disaster scenario was that market uncertainty from bank runs in Greece would have caused bank runs in Spain, Portugal and Italy, which combined represented roughly 34.5 percent of the euro zone’s economy. Add in banking system exposure from other European countries and Europe would have had a full-scale crisis on its hands.

Bailout or no bailout, Greece was a big deal and Cyprus is no different. If the EU decides to throw some cash Cyprus’ way, conditional upon the right reforms, it would reinforce the precedent set with Greece. If, on the other hand, Cyprus gets no help, the precedent that the Eurocrats worked so hard to set with three painstakingly negotiated Greek bailout packages would fall into question.

Despite Cyprus and Greece being the same in precedent, the fundamental problem facing Cyprus is actually very different from that of Greece. The little island’s woes stem from an over indebted banking system — with the third-highest level of private debt as a percentage of GDP in Europe — while Greek insolvency came about from a lack of competitiveness papered over with heavy government borrowing (ironically, Cyprus was one of the main creditors).

Unlike Greece, government debt is not at the root of Cyprus’s problems. Public debt-to-GDP is below both the euro zone and European averages by 16 and 11 percentage points, respectively.

The experience of Ireland — the country with the second-highest private debt-to-GDP ratio in Europe— offers guidance of what Cyprus ought not to do.

In 2008, as soon as the financial crisis exposed the poor quality of Irish banks’ property investments and confidence in Ireland’s banking system crumbled, the government guaranteed private bank obligations and requested European bailout funding (initially committing to not impose haircuts, but reneging on that commitment in 2011).

Ireland’s pre-crisis public debt-to-GDP ratio of 25 percent quickly grew to 65 percent in 2009 and then to over 100 percent in 2011. As a result, the Irish have been struggling to bring this figure back down for several years in compliance with tough austerity measures. A far better solution would have been to wind down failing banks (instead of propping them up) and impose haircuts early on.

At the end of the day, the EU will grant Cyprus its money. Risking the stability of the entire currency bloc just isn’t worth saving a few billion euros.

But Europe should think twice before simply handing out a bailout package equal to the entire Cypriot economy.

As Ireland’s current plight shows, burdening the taxpayers to save the banks and bondholders imposes unnecessary and long-lasting pain. Once the European Union provides the stabilization funding needed to prevent Cypriot contagion to the rest of the euro zone, the EU ought to set a new precedent going forward: that inefficiency has the freedom to fail.