Cyprus, the eurozone and civilisation as we knew it

by George Hatjoullis

International Monetary Fund's Managing Directo...

International Monetary Fund’s Managing Director Dominique Strauss-Kahn (L) talks with , European Central Bank President Jean-Claude Trichet (C) and Italy’s Governor Mario Draghi (R) prior to the start of their G-7 meeting at the Istanbul Congress Center (Photo credit: Wikipedia)

The ECB press conference has just finished and my first reaction was; wow. The ECB President was asked about a Republic of Cyprus eurozone exit. His reaction to this type of question in the past has been to dismiss the question and remind everybody that membership of the eurozone is irrevocable. Not so it would seem with respect to the Republic of Cyprus. He merely noted that the economic problems facing Cyprus would exist outside of the eurozone (true enough) and added that the Republic might find resolving these problems more difficult outside of the eurozone. He omitted to explain why, or to address the fact that outside of the eurozone the Republic can devalue its currency. Anyone wondering how valuable this degree of freedom can be should compare Iceland with eurozone crisis member state economic outcomes since 2008. No one asked him about this degree of freedom, nor about the significance of capital controls within the euro zone. Apparently, temporary controls in a small, insignificant, country like Cyprus are consistent with a well-functioning monetary union.

The original Cyprus plan to tax all depositors, he described as a bad idea. Perhaps it was from the point of view of the eurozone as it might have alarmed people. In fact, as I have already noted in an earlier blog, viewed as a wealth tax, the idea was unremarkable. Moreover, it would have been preferable for the Republic compared to the agreed resolution. It seems much of what has transpired has been for the benefit of the eurozone rather than Cyprus.

The Cyprus resolution is not a template. Too right it is not. They would not inflict this kind of destruction on any other member state. Once again, an earlier blog explains why Cyprus has been singled out for such particularly callous treatment. Draghi is correct in arguing for a banking union agreement sooner rather than later and seems to argue that a single resolution agency needs to be established separate from individual member states. Impossible to argue against this idea but it does require collective finance and common ex ante rules. Might work for the eurozone but what about non-eurozone EU states? The EU is a long way from banking union.

Draghi admits that the risks to the eurozone economy are on the downside, inflation is well contained and monetary aggregates are not growing. Yet he confirmed that interest rate cuts are not on the agenda. The reason is that conventional monetary policy is ineffective given the dis-integrated eurozone economy and non conventional tools (OMT) are preferred. Hard to disagree on this point.

The upshot of the press conference is that Cyprus is unimportant to the eurozone project and has been a useful exercise from the point of view of the eurozone authorities. The eurozone is in no existential danger as a Cyprus exit does not matter to anyone except Cyprus.

All I would add is that Cyprus is damned in and out of the eurozone. The fantasy masquerading as economic forecast in the latest memorandum of understanding does not give the true picture. GDP will fall by much more than 8% in 2013 and will not be bouncing back in the perky way described. A primary surplus of 4% of GDP in 2018, let alone 2016, is looking challenging. It will need a second rescue package in due course which makes a mockery of the idea that the present destruction will put the economy on a sustainable debt path. The situation is now so severe from the perspective of the Republic of Cyprus that exit and devaluation may be the best of a really bad situation.