Cyprus and the others - what are bailouts for?
Since the beginning of the crisis, five countries had to be bailed out by their EU partners: Greece, Ireland, Portugal, Spain (for its banks), and most recently Cyprus. Bailouts happen when a country becomes unable to roll over its sovereign debt on international capital markets due to vanishing investor confidence, generally triggered by the poor state of a country’s public finances and signalled by rising interest rates.
Out of all the recent EU bailouts, the Cypriot one was doubtlessly one of the messiest. Cyprus turned out to be an unusual bailout as, for the first time, Eurozone members refused to lend the full amount needed by the country to avoid defaulting on its debt (€17bn). They only accepted to lend €10bn and asked Cyprus to fill the gap by forcing its oversized banking sector (worth more than 700% of GDP and the main source of troubles) to contribute. The drama around Cyprus came from the fact that the country accepted to force not only its banks’ creditors to contribute, but also the banks’ depositors, whatever the amount they had in the bank. This was a huge mistake as, in the EU, all bank deposits up to 100,000€ are supposed to be guaranteed, whatever happens to banks. This could have triggered a massive EU-wide bank run. Indeed, if Cypriot depositors were to lose money in a banking crisis, it would have been perfectly rational for Italian and Spanish depositors to start withdrawing money from their banks, thereby triggering the collapse of the entire EU banking system.
EU bailouts’ impossible trilemma
EU bailouts cannot be perfect as they face an unusual “trilemma”: a situation in which they have to fulfil three requirements, which cannot all be attained at the same time. The first requirement is financial: the primary function of a bailout is to avoid a disorderly sovereign default – which could threaten the euro’s existence – by helping a country finance its sovereign debt until investor trust returns. The second requirement is economic: the money lent by Eurozone members to a troubled partner comes with “conditionality” – generally a set of economic policies to be implemented in order to improve the long-term prospects of the country’s economy. The third requirement is political: due to the dramatic social consequences of the crisis, it is challenging for the EU to ensure that a) a bailed-out country’s government is able and willing to implement the tough measures (reducing public spending, structural reforms, etc.) and b) that the pro-Euro, pro-reform, government is not overthrown by rising popular discontent and extremist anti-EU political parties (for a more detailed analysis, ask Mario Monti and Antonis Samaras).
No recipe for a perfect bailout
It is impossible for the EU to fulfil the financial, economic and political requirements of a bailout; hence one requirement is always sacrificed. This is why bailouts are always messy and attract a lot of criticism. If the EU decides to ensure maximum investor confidence and radical economic reforms, the efforts demanded might be too much for a country’s population to take, let alone for the government to remain in power. If the EU decides to ensure investor confidence while avoiding too radical measures in order to limit short-term pain for a country’s population and make sure a pro-EU government stays in power, the economic requirement is sacrificed as the bailout doesn’t improve the country’s long-term economic prospects. Finally, if the EU decides to limit radical reforms and budget consolidation in order to limit political pain and improve the country’s long-term economic prospects by sharply reducing indebtedness, it will have to force investors to take a loss on the sovereign debt they hold (as it happened for Greece), thereby causing widespread market uncertainty.
Hence, EU bailouts are doomed to be imperfect. Now, finding the second-best solution depends on each country’s specific situation, as the three requirements differ in intensity. With Cyprus, the newly elected head of the Eurogroup, Dutch Finance Minister Jeroen Dijsselbloem, provided a perfect answer to the question: “How to ruin your international credibility in a few words?” By saying that in all future bailouts, the EU would start by forcing losses upon bank creditors and depositors before lending EU money, he was basically telling international investors not to invest in EU banks and EU depositors to withdraw their money as soon as possible, to avoid taking a hit. Thankfully and unsurprisingly, he quickly changed his mind. EU bailouts are doomed to be messy, but this should not be an excuse to leave the euro implode or demonize the EU for creating problems when it is only trying to solve them.