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The Euro Crisis after Cyprus: What We Have Learned



Just as suddenly as it arose, the Cyprus financial crisis has passed by. The banks have opened and so has the stock market without undue panic. A few steps remain in the euro crisis, but this crisis is abating, and however messily Europe has handled it. Today, the questions are what we have learned, and which new principles of economic policy have been established.

The euro crisis is fascinating. Instead of being a game with set rules and a steady group of players, both the rules and the players alter over time or are at least challenged by other rules and players. The painfully slow resolution of the chaos has increased the cost, but the pace has allowed us to figure out what works and what does not. Thanks to this chaotic trial-and-error process, we can discern the essence of financial stabilization policy.

The first lesson is that the euro area has survived because survival is its members' top objective. If any country had departed from the Economic and Monetary Union (EMU) in the midst of crisis, it would have faced a severe devaluation, which has often amounted to 75 to 80 percent in such crises (e.g., Argentina 2001, Indonesia 1997, or Russia 1998). Such large devaluations cause mass bankruptcies, huge bank crises, and massive output collapses. Had there been a departure from the euro area, other weak members would have suffered from bank runs, leading to bank crashes. Uncleared balances between the euro countries would have assumed a life of their own, leaving the creditor countries with large claims of dubious quality, while the debtor countries could have easily been forced into default.

A corollary lesson is that capital controls can be applied only for a very short period to avoid panic, as is now being done in Cyprus. If the capital controls are maintained any longer, cash euros and bank euros in Cyprus will diverge, as depositors in Cyprus will offer discounts on their deposits to get their money out of the country. Then cash euros and bank euros in Cyprus would acquire different values; Cyprus would effectively have left the euro area, since its euros would no longer be fully convertible. Thus, capital controls, which are permitted according to Article 65 in the EU Treaty, must not last longer than, say, a month.

A second lesson came in March 2012, when Greece defaulted but stayed in the euro area, proving that sovereign default did not have to cause its departure. But the cost was high, as is evident from the high bond yields not only in Greece but also in other weak EMU countries—i.e. Ireland, Portugal, Spain, and Italy. Thus, as much as possible, default must be avoided.

The earlier Deauville statement in October 2010 by French President Nicolas Sarkozy and German Chancellor Angela Merkel that opened the door to default but put the whole burden on private bondholders—the so-called PSI, or private sector involvement—can be seen now in retrospect as a mistake not to be repeated. If a default is inevitable, it should be made sufficiently large and broad. It is unacceptable that all kinds of EU regular and emergency lending institutions have claimed preferential treatment as creditors, like the International Monetary Fund (IMF). As a result of this step, the European Central Bank (ECB) has reaped a big capital gain on the Greek default at the expense of private bondholders. The consequence will be a disproportionately higher yield, that is, government cost, for EU countries' bonds. Eventually, the EMU should issue euro bonds with claims on all the states of the EMU countries and thus lower yield.

Third, the great cost of default underlines the importance of returning the original Stability and Growth Pact that was demolished by the European Council in 2003 and 2005 by Germany, France, and Italy. Hopefully, the new EU fiscal compact of March 2012 has addressed these problems. The Treaty on Stability, Coordination, and Governance of the Economic and Monetary Union is a new and stricter version of the old Stability and Growth Pact, signed by all the 27 EU members apart from the United Kingdom and the Czech Republic. It came into force on January 1, 2013. It offers the European Commission much greater powers over the control of member states budgets.

Fourth, good fiscal policy before the crisis is not enough. Three groups of countries have ended up in financial crisis in spite of decent fiscal policies before the crisis—first, Ireland and Spain, second, followed by the three Baltic countries, and, finally, Slovenia and Cyprus. These cases offer different lessons.

Ireland and Spain were classical banking and real estate boom-and-bust stories. Bank regulation in these countries should have been stricter, which is the case also for most EU states. Such regulation should be carried out on an EU basis because of far-reaching internationalization of EU banking. The decisions by the June 29, 2012 EU summit to establish a banking union and later to render the ECB a common bank regulator have taken care of that problem in principle. The broad collapse of the European banking system shows that a much higher capital-to-assets ratio will be required in the future.

Another lesson from Ireland and Spain is that banking debts should not be automatically taken over by the state, as happened in Ireland. That takeover was a joint mistake by the Irish government and the ECB. It must not be repeated. Private bank debts must not be guaranteed by governments, only bank deposits up to a certain level, currently €100,000. If a bank goes under, its shareholders should be wiped out, followed by its bondholders, and finally bank deposits exceeding €100,000, as was correctly done in Cyprus. Denmark has followed this approach repeatedly with several small banks during the current crisis, and no significant concerns have been raised. The bad habit of governments bailing out European banks without costs to managers, bondholders, and large depositors must come to an end.

The Baltic countries—Estonia, Latvia, and Lithuania—were the first to be hit by severe crisis. They were greatly overheated, with large current account imbalances, but their fiscal affairs were in good order before the crisis. The reason for their huge output declines was not austerity, which occurred later, but a near complete liquidity freeze. Whereas the US Federal Reserve salvaged Sweden and Denmark with giant swap credits in the fall of 2008, the ECB failed to do anything for EU countries outside of the euro area. In the future, the ECB should have the duty to provide all EU countries with necessary swap credits. The three Baltic countries have learned their hard lesson, all hastening to join the euro area, which Estonia has already done.

Cyprus and Slovenia ended up in banking crises somewhat similar to those in Spain and Ireland, also pursuing conservative fiscal policy before the crisis. To a considerable extent, Cyprus suffers from collateral damage from the Greek default. Slovenia has the special problem of old state banks that have gone under or been privatized long ago in other post-communist countries.

Ironically, the IMF judged that in 2008–09 Cyprus, Slovenia, and Spain all had "fiscal space" and encouraged them to increase their budget deficit for the sake of "fiscal stimulus." They all did so in 2009. But as a result they ended up with budget deficits of about 6 percent of GDP. It then became much easier to increase the budget deficit than to slim it down. To a significant extent, these three countries are the victims of irresponsible policy advice from the IMF.

Small countries with illiquid bond markets and limited GDP can easily face sharply rising bond yields or even lose access to international market financing. Latvia did so when its public debt was less than 20 percent of GDP in 2008, and Slovenia in 2012 when its public debt was about 50 percent of GDP. A public debt of 60 percent of GDP is too high a ceiling for such countries, and a lower ceiling of 30 or 40 percent of GDP would make more sense. Fabrizio Coricelli (2007, 83) presciently noticed that "the Central European countries have let their budget deficits surge and their debt levels rise."

The Cyprus crisis resolution suggests an additional lesson. On the one hand, it is vital to maintain deposit insurance up to €100,000 to offer ordinary people an elementary sense of security. Otherwise, people (rightly) take to the streets. The larger deposits should not be treated as sacred, as has been the case in most of Europe. The order of claims is clear. Shareholder capital comes first, second come the bondholders, and third the large bank deposits. If the prices of various bank-related assets adjust accordingly, that is fine. The Lehman Brothers bankruptcy has led to an unwelcome tendency to bail out all banks. Given the high interest rates on Cypriot bank accounts, these deposits must be considered speculative and thus vulnerable as legitimate claims on failing banks. Only under extreme circumstances should states bail out banks.

The EU countries that have had the highest economic growth during the crisis are Poland and Sweden. Both have benefited from depreciation, but they also pursued relatively conservative fiscal and monetary policies before the crisis. Therefore, they could carry out a limited fiscal stimulus in 2009 without risking fiscal problems. In general, Northern Europe, adhering to conservative policies, is in far better economic shape than Southern Europe. The obvious conclusion is that the fiscal stimulus policy that was preached by the IMF, the United States, the United Kingdom, and France was not only dubious but outright dangerous. This policy becomes all the more dubious as the IMF maintains the same argument in 2013 nearly five years after the crisis erupted. Then, fiscal stimulus can no longer be considered a short-term policy, which it ought to be.

To sum up, the 10 main lessons learned by the European Union are:

  1. It is vital to maintain the euro area.
  2. Countries in financial trouble have to be bailed out. Accordingly, the European Union created the European Financial Stability Facility (May 2010) and later the European Stability Mechanism.
  3. The Stability and Growth Pact has been renewed and reinforced. Fiscal discipline is in the common interest. Hopefully the new Fiscal Compact will take care of that.
  4. Fiscal stimulus has proven of little value apart from for a brief period in 2009 in a few countries with very strong public finance (Sweden and Poland), whereas it helped to plunge several countries into crisis (Spain, Cyprus, and Slovenia).
  5. For small and weak countries, a lower public debt ceiling than 60 percent of GDP is desirable.
  6. Banks must be allowed to go under. Not only share capital but also bonds and large deposits in that order should be permissible claims. State bailouts should be considered only in extreme cases.
  7. Banks need to be more firmly regulated and required to have much more capital to assets. The new EU bank regulation under the ECB will hopefully lead in that direction.
  8. Sovereign default should be avoided at almost any cost, but sometimes it is necessary. If so, EU government claims should not be shielded.
  9. Euro bonds remain desirable to reduce public borrowing costs. No step has been taken in that direction.
  10. The ECB should be prepared to offer swap credits to other non-euro EU members in the case of a new crisis.

The costs of changing the rules from country to country are becoming excessive. Markets do not know what to expect next. Politically, the effect of this confusion of rules is likely to be even worse. The crisis is not over. Slovenia will need a bank restructuring, and several IMF programs are ongoing. It is time to settle for the rules outlined above and stick to them for all countries.

As the crisis proceeds, a new consensus is arising. People and policymakers realize that there is no easy solution. There is no low-hanging fruit. Therefore we had better go for the option with the highest reward.


Coricelli, Fabrizio. 2007. Design and Implementation of the Stability and Growth Pact: The Perspective of the New Member States. In Europe after Enlargement, eds. Anders Åslund and Marek Dabrowski. New York: Cambridge University Press.

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