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Morici: Cyprus Would Do Better to Leave the Euro

A demonstrator outside the Cypriot parliament in Nicosia, Cyprus
Bloomberg/Contributor | Bloomberg | Getty Images
A demonstrator outside the Cypriot parliament in Nicosia, Cyprus

Cyprus would be better off to leave the euro than accept the terms of the bailout imposed by the European Union, International Monetary Fund and European Central Bank.

Until recently, Cyprus was a prosperous island economy thriving through strong tourism, shipping and maritime related activities, and a significant international financial sector.

Its major banks have branches in Russia, the Ukraine, UK and other overseas locations, and have attracted large offshore deposits. Cyprus has gained great popularity as a portal for western investment into Russia, Central and Eastern Europe, China and India.

(Read More: Russia Loses Out as Cyprus Reaches Deal)

Much like New York City, London and other big-city European banks, the Cypriot banking sector attracted deposits much larger than it could productively use lending in its local economy and invested in other financial instruments—Cypriot banks invested heavily in Greek sovereign debt.

The 2012 Greek government bailout engineered by the European Union, International Monetary Fund and European Central Bank imposed losses greater than 50 percent on foreign bondholders—among those, Cypriot banks. Hence, the Troika, which is now imposing severe conditions in exchange for aid to bailout Cypriot banks, bears substantial responsibility for the present sad state of their balance sheets.

(Read More: El-Erian: Cyprus Deal 'Very Challenging')

During the recent U.S. financial crisis, the Federal Deposit Insurance Corporation was adequate to restructure and secure deposits at smaller banks; however, the Federal Reserve printed hundreds of billions of dollars to purchase and work out souring bonds held by larger banks, and the Treasury borrowed similar sums to inject new capital into those banks. More importantly, depositors—large or small—did not lose any money during or after the U.S. crisis.

The European Central Bank lacks the tools to participate in such bank workouts, and the European Union lacks the borrowing authority of the U.S. Treasury—and the taxing powers to back up bonds. Hence, banks in Cyprus, just like those in Ireland and Spain in their banking crisis, lack a lender of last resort to keep them afloat while they restructure and work off losses through new, sounder business activities.

In the United States stockholders lost equity when banks went sour, but it kept the banks open and depositors kept their money. The Troika, in exchange for $10 billion in aid, will likely impose losses of at least 20 percent on large depositors and require Cyprus to slash the size of its banking sector, relative to gross domestic product, to the average for the European Union as a whole.

(Read More: Will the Cyprus Deal Take the Euro Far?)

If such a condition were imposed on New York City, its economy would collapse and the Big Apple would suffer massive unemployment and huge population losses, as workers sought employment opportunities elsewhere.

Cypriots lack that option—employment opportunities in depressed Greece are quite limited—and most Cypriots lack the language skills to find jobs reasonably comparable to their current situations in other European countries. Instead, unemployment will rocket, GDP and tax revenues will plunge, and Eurozone rules limiting budget deficits will force Cyprus to impose severe austerity measures, further exacerbating the downward spiral.

Cyprus could turn down aid from the EU, IMF and ECB, take its large banks through bankruptcy and withdraw from the euro altogether. That would also impose big losses on depositors and equally catastrophic consequences for confidence in the single currency. However, its comparative advantage as a portal into Eastern Europe and Asia would remain.

Taking its largest financial institutions through bankruptcy and establishing a local currency will be no cake walk, but the austerity measures—higher taxes, restraints on government spending and so forth—that come along with EU aid would likely throw Cyprus into the same downward spiral as Greece and Spain.

Iceland is also a financial center but having its own currency, recovered rather quickly from a similar financial crisis. Cyprus, a similar island nation with substantial economic assets, would likely find it better to just go it alone too.

With that, Greece, Spain and other could then see the wisdom of following Cyprus out of the euro, spelling the eventual end for the sham that is the European currency.

(Read More:'We Feel Like Crying': Cypriots Lament 'Terrible' Deal)

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist.You can follow him on Twitter @PMorici1