Sad Cyprus

Mar 12th 2013, 14:50 by Buttonwood

SMALL though it is, Cyprus is emblematic of this current debt crisis. For a start, it illustrates that focusing on a country's government debt-to-GDP ratio is too narrow; in 2010, Cyprus had a government debt-to-GDP ratio of just 61%. Debt is a claim on future wealth; when it becomes clear that future wealth will not be sufficient to service this debt, a crisis will ensue. If the debt is in the private sector, and particularly the banks, the government will be dragged in; either because the economy (and tax revenues) collapse or because the state must formally assume the debts of the banking sector.

As this note from a World Bank economist points out, banking debt at end-2010 was around nine times Cyprus's GDP. Both the size of the banking sector to the economy, and its Topsy-like growth, are analogous to the situations of Iceland and Ireland. (In Luxembourg, the size of the banking sector is around 20 times GDP but this is almost completely comprised of foreign banks. In Cyprus, domestically-owned institutions account for two-thirds of all bank assets.) Furthermore, even when financial institutions are excluded, Cyprus has the second highest private sector debt-to-GDP ratio in the euro zone.

When the banking sector is so large, the domestic government clearly cannot stand behind it. Iceland needed an IMF loan; Ireland went to the EU. As part of this process, some of the debt will have to be written off. But that's the tricky bit. Who pays? If you write off debt owed to the domestic banks, then you will have to rescue the banks. If you write off uninsured deposits, then will there be a contagion effect as uninsured depositors in other countries take fright. And if you write off debt owed to official creditors, they will demand a price, in terms of austerity; that price will cause short-term damage to the economy and will be resented by the electorate.

The problem is tied up with the issue of moral hazard. This can be applied to both creditors and debtors; the former should be punished for reckless lending and the latter for living beyond their means. The collapse of Lehman Brothers is seen as an example of the faulty reasoning behind moral hazard; by letting the bank go bust, the crisis was spread throughout the financial system. But rescuing every creditor (or intervening to bail out the markets every time they falter) is the reason we are in this mess.

The best opportunity for the authorities to apply the moral hazard lesson is when the economy is going well. But at that moment, financial institutions aren't going bust. In retrospect, the opportunity was missed when Long-Term Capital Management collapsed in 1998 but at the time, everyone was worried about the Asian crisis.

Because Cyprus is small, adding its debt to that of the stronger EU nations will not make that much difference. But as a whole, the euro zone is not growing at all; the consensus forecast is for a 0.2% decline in GDP this year. If we go back to the unholy trinity of options facing indebted nations (inflate, stagnate, default), it looks as if the EU, like Japan, is opting for the second.