Crisis Management Lessons from the Cyprus Crisis

The Cyprus crisis has produced a large number of negative comments about governance in the eurozone, especially with respect to the predominant influence of Germany in the negotiations, the ultimatum issued by the European Central Bank (ECB) and the weakness of the European Commission, which was unable to block the proposal that bank deposits of less than 100,000 euros should be taxed.

The rules of the democratic game

Even though these critics raised important issues, the difficulties in reaching an agreement were mainly due to the huge scale of Cyprus’ financing needs (about 80% of GDP, 30% of which had to be through adjustment measures) and the difficulties of attracting the political support needed for such a massive adjustment effort. The initial agreement represented a compromise between the demands of the Troika, whose vision was confined to the effort to be made and the desire of the Cypriot authorities to accommodate their Russian partners, so as not to compromise the business model on which the Cyprus economy’s development had been founded ever since Cyprus joined the European Union. In the end, the Cypriot parliament rejected the initial plan, thus confirming the limits of the Troika’s powers.

The rules of the democratic game also influenced the stance adopted by the German government, which set out its position in close collaboration with the German parliament, carefully scrutinised by the press. Naturally, the German chancellor, Angela Merkel, was not ready to make concessions that would weaken her chances of winning the forthcoming legislative elections. This was particularly the case since the lack of transparency in Cyprus’s banking system and its links with the Russian oligarchs have become an issue in the electoral campaign.

This highlights the important role that national parliaments can play in resolving the eurozone crisis. The situation imposes much stricter constraints on the Troika than those to which the International Monetary Fund (IMF) had been subject for decades in its adjustment programme negotiations with African and Latin American countries—countries that were far from being models of democracy.  Even if this reality complicates decision-making and creates uncertainty, it is an acceptable price to pay for democracy.

Eurozone fragility

The Cyprus crisis confirms that the eurozone remains fragile. A member state, however small, can cause tensions that could result in the collapse of the euro. This situation is a direct consequence of the fact that the eurozone is not a political union. If it were the case, the Cyprus crisis could have been settled easily, since Cyprus’ financing needs would have been measured in relation to the eurozone’s GDP. Set against this yardstick, it only represents 0.1% of the eurozone’s GDP.

This figure illustrates the schizophrenic position in which the European authorities find themselves. They were ready to letCyprusexit the eurozone for “a handful of euros”, despite the high cost that this would have entailed. This attitude can be explained by the surplus countries’ limited willingness to pay for the economic mismanagement in general, and fiscally imprudent economic policies in particular, in crisis countries, which need to understand that they have to obey the eurozone’s rules of good conduct. The surplus countries hope in this way to avoid facing again crisis situations in which the only solution is that they fork out when a problem arises for which they are not responsible.

The problem of moral hazard would not arise in a political union, as this would enable the centralisation of responsibilities within a federal government. In such an institutional configuration, severe economic policy slippages at a member-state level would be dealt with the supranational institution, thereby avoiding political confrontation between member states.

By centralising the supervisory and crisis resolution functions, the creation of a banking union would constitute an important stage in the reinforcement of the eurozone’s architecture, on condition that European leaders came to an understanding as to the mechanisms to be set up and their method of financing. Yet a banking union will not be sufficient to guarantee the long-term survival of the euro since not all of the crises find their origin in the banking sector.

Enhanced crisis management approach

TheCypruscrisis also reveals weaknesses in the way in which the Troika has conducted negotiations with theCyprusauthorities.

This situation can be explained by the fact that the European Commission and the IMF failed to agree on certain fundamental points of the programme. This would not happen if the eurozone were capable of financing adjustment programmes via a single institution.

This task could be assigned to the European Stability Mechanism (ESM) under the control of its board of directors and consequently the Eurogroup. The IMF could participate in the financing but the ESM should be in a position of being able to finance the programme independently without having to depend on conditions laid down inWashington.

The European Commission ought to remain responsible for supervising the economic and budgetary policies of the member states and, if a crisis were to arise, it ought to be a party to the negotiations in order to guarantee that the measures proposed were not in breach of European law. As for the ECB, it should remain at a distance from the negotiations. It should clearly fix the rules for its interventions as a lender of last resort, if necessary by defining the circumstances in which its interventions would be conditional upon a guarantee being provided by the ESM. The aim of such clarification would be to avoid giving the impression that the fate of a country might depend on the ECB. Ultimately, the future of the eurozone depends on political decisions rather than on the central bank.

The Cyprus crisis also confirmed that negotiations with a country in difficulty could take time. In order to prevent the situation from degenerating, the eurozone needs to develop a procedure for clarifying the instruments that could be used in order not to force the negotiators to reach an agreement in the course of a single weekend. Such a procedure should rely on the ECB’s rules for intervention as the lender of last resort. It ought also to specify the eurozone doctrine in relation to capital controls.

The European authorities have succeeded hitherto in learning lessons from the various developments in the eurozone crisis. It is to be hoped that they remain on the alert so as to be prepared to deal with further episodes of this kind under the best possible conditions.

One Response to "Crisis Management Lessons from the Cyprus Crisis"

  1. Mike   April 16, 2013 at 2:21 pm

    Well written. Thank you.