Cyprus a special case for the eurozone: moral hazard revisited

by George Hatjoullis

English: Rabbi Arie Zeev Raskin meets the last...

English: Rabbi Arie Zeev Raskin meets the last President of Cyprus Mr Tassos Papadopoulos (Photo credit: Wikipedia)

Much has been said and written about the harsh and exceptional treatment of Cyprus by the troika. It should be understood however in what way Cyprus is exceptional. The treatment of Cyprus is consistent with the principle underlying all bailouts since the start of the crisis, namely the avoidance of moral hazard.

The concept of moral hazard (  may not be familiar to all. It is analogous to the concept of tough love. A wayward child might be allowed to suffer more than is necessary in order to teach it not to be wayward. In the context of the eurozone crisis it refers to the risk that a member state may be deterred from taking action to correct conditions that generated their crisis by the very assistance that is being provided. Berlin established this as the guiding principle of all bail-outs from the first bail-out. In the view of Berlin the greatest existential risk to the eurozone was the existence of moral hazard. If it could not be eliminated then crises would repeat and a perpetual need for fiscal transfers would arise, which would ultimately undermine the eurozone.

Once this position is understood then everything that has transpired since Greece kicked off this crisis makes sense. Each rescue package was individually tailored to incentivize the member state being rescued to implement fundamental reforms and necessary fiscal disciplines. New treaties were introduced to ensure such disciplines were enshrined in national law. For Berlin, the eurozone does not constitute a federal structure in which fiscal transfers are part of the stabilisation process, as is evident in other monetary unions ( For Berlin the eurozone constitutes a set of states all running their fiscal policies on German lines and never needing substantial fiscal transfers. The issue of whether the German vision is stable is for another blog. The important point is that this vision underlies the crisis management process.

The reason Greece and Cyprus were exceptional cases is simply because the troika felt that moral hazard is greatest with these two member states. In colloquial terms, Greece and Cyprus need more tough love than other member states. They simply trust Greek and Cypriot politicians less than Irish and Spanish. The question thus arises why does the troika feel that this lack of trust is appropriate for Greece and Cyprus?

Now if I wanted to be facetious I could try to infer something from the neutrality of Ireland and non-belligerent status of Spain during WWII, in contrast to the ferocious resistance of Greece (Cyprus was of course a British colony). However, if I were to take this line I may as well go back to the conflict between the western Roman empire and eastern Roman empire. Not a fruitful line of inquiry.

What about religion? Greece and Cyprus are the only orthodox christian countries in the eurozone. Elsewhere Catholicism dominates. Even in Germany, the home of Martin Luther, Catholicism remains the dominant religion in Bavaria (where the Bavarian Motor Works originate) and Saarland. Germany contributed the outgoing Pope. Echoes of the conflict between the western and eastern Roman empire and again not really fruitful.

However, the orthodox religion aspect may have legs. The newly liberated Russia has returned to its orthodox christian roots. Moreover, the bad boy of the Balkans, Serbia, is orthodox christian. Indeed the whole sorry mess in the Balkans seemed to kick off when Germany recognised Croatia as an independent state. Croatia is not orthodox christian. This orthodox christian link does lead to another area where distrust is evident; money laundering.

The German conviction that Cyprus has been used to launder ‘dirty’ Russian money has been a constant theme. However, the theme goes back a long way and involves ‘dirty’ Serbian money as well. Indeed it allegedly involves the notorious Slobodan Milosevic ( See the article in the FT, October 31, 2006, A Cypriot law firm is accused of facilitating the illegal transfer to the Island of billions of dollars by Slobodan Milosevic. Another important aspect of this article is that it mentions that the law firm in question was founded by none other than Tassos Papadopoulos.

Tassos Papadopoulos was the fifth president of the Republic of Cyprus and served between February 28, 2003 and February 28, 2008. Tassos was president at the time of the money laundering court case. However Tassos’ true claim to notoriety was in relation to the Annan plan referendum. The referendum took place on an April 24, 2004. Tassos Papadopoulos advised Greek Cypriots to vote NO. This came as a surprise to the EU. It had evidently expected both sides to accept the plan and for Cyprus to join as a united island. They must have had some reason to believe this would be the case. For one thing, they did not expect the president to advise against.  The accession process was by then impossible to stop and the Republic of Cyprus joined the EU on May 1, 2004 whilst the occupied north of the island remained an unrecognised state.

The distrust of Cyprus politicians may thus have deep roots. It is immaterial whether it is justified and the purpose of this blog is not to judge. The purpose of this blog is to inform in order to aid comprehension. If we add to this the self-evident refusal of the outgoing administration to address structural weaknesses in Cyprus fiscal policy and the overwhelming vote against the deposit levy, then the picture is complete. The troika judged that moral hazard was a serious risk in Cyprus and delivered some very tough love.

The problem is that it is too tough. Moreover, the troika must know this to be the case. The destruction of the offshore banking industry is too big a shock for the Cyprus economy to adjust. The elimination of around 5 billion euros of liquid wealth, almost one-third of GDP, overnight, is an unbelievable economic shock. Moreover, there are other taxes and austerity measures to come. Any forecast of economic growth is too optimistic and unrealistic. This is an unprecedented situation and the near term outlook is bleak. Importantly, the 10 billion euros (which has yet to be approved) to be loaned to Cyprus as part of the ‘rescue’ will clearly not be enough. The argument by the IMF that all this was necessary in order to ensure a sustainable debt path is disingenuous. It does not lead to a stable debt path. It leads to economic collapse and euro exit.

[There is an excellent article on the moral hazard issue in today’s FT. Worth a read.] (