We have seen the debt hot potato passed around Europe, with countries including Portugal, Ireland, Italy, Greece, and Spain (PIIGS) requiring massive bailouts to stave-off default on their national debt. Cyprus is the latest in this long line of countries with heavy reliance on social programs and guaranteed jobs and benefits from the government to saunter up to the EU and IMF, hat in hand, requesting bailout money. Cyprus’s banks have been closed since Saturday, and will not open, at the earliest, until Tuesday. The EU has given the country until Monday to come up with 5.8 billion euros to supplement the EU’s 4.2 billion euro contribution to the necessary 10 billion euro bailout of the Cyprus banking system.
Although Cyprus represents a paltry 0.2% of total EU GDP, it is an EU member country, one of 27 (I’ll get back to this point shortly), and is therefore important, no because of its economic contribution, but rather because its financial failure could force the dissolution of the EU itself. Cyprus’s parliament is voting at the moment on some kind of package to raise the needed capital to avoid the failure of their banking system. Cyprus failed in its attempt to secure a loan from Russia, which has a vested interest in Cyprus due to its (Cyprus’s) lax banking rules, making it a safe-haven for money launders and those with ill-gotten gains from shady (illegal) businesses. Many Russians have substantial assets in Cyprus, so it would make sense that Russia would want to provide support, but they refused.
What is most shocking to me is the relatively small amount of money needed to solve this issue, at least in the short-term – 10 billion euros, or about $13 billion. Compared with the hundreds of billions of euros that some larger countries owe, this is peanuts, yet the EU is refusing to supply the funds, putting at risk the entire structure and future of the EU. My conclusion is twofold – one, that they just can’t afford to keep bailing out these countries, and two, that they want to establish a precedent to let other countries know that they are not going to bail them out if they make poor financial decisions. While I agree with the second approach (this is the same moral hazard argument that we saw here in the U.S. with the “too big to fail” debate about our banking system), the first is another story. There are 27 EU member countries, and it appears very likely that the EU and IMF just don’t have the resources to deal with all of the debts of these countries collectively. Since all 27 countries are responsible for providing their proportionate amount of financial support for EU members (proportionate to their respective GDP), in essence they are responsible for providing the very liquidity they they need. To put it another way, they are responsible for bailing themselves out. The problem is that they just don’t have the money, as a group, to pay the bill.
If Cyprus falls out of the EU (if they can’t raise the 5.8 billion euros for this bailout), the entire EU is at risk of collapse. Even if we get through this crisis with Cyprus, and they are truly stabilized by this bailout (not likely since they will no doubt need more money in the future to stay afloat), there are many other EU member countries with similar problems, including Slovenia, which will be the next domino to fall.
The EU has given Cyprus until Monday to put the money on the table, or they will cut Cyprus off from liquidity, which means their banking system will fail and they will be in default. If this happens, Cyprus will fall out of the EU – they will have no choice, since maintaining the euro as their currency will be impossible. Once this happens, I believe the EU will fall apart. The major countries – Germany, France, Italy, the UK, and maybe Spain will maintain some kind of economic union and will probably still use the euro (the UK still uses the pound anyway), but as an economic force, the EU will be dead.
U.S. markets don’t seem to care (at all) about this crisis. Although the Dow was down 90 points yesterday, we are right back up this morning, about the same amount that we lost in yesterday’s session. Investors either don’t understand the implications, or just don’t care, but ultimately the EU matters. We sell about 25% of total GDP to EU countries, so our economy certainly depends on that market. There are, of course, currency implications, liquidity implications, and psychological implications of an EU collapse for the U.S. economy and our markets. Ultimately the EU is going to come calling, with hat in hand, looking for a big check from us to solve their problems – problems which they obviously cannot afford to address. We will be in the same position with the EU and the EU is with Cyprus today – either force them to deal with their own financial problems, or face the economic damage that will result from an EU collapse.