By Jerry O’Driscoll

Cyprus is the latest country to succumb to the financial rot in the European Union. Once a banking center, its citizens now cannot pay for their own imports. Exporters are demanding cash only for goods sent to Cypriote businesses. Credit has dried up. Businesses are closing because they have no goods to sell.

The economic crises in the various countries have fallen into two types. In the first type, highly indebted governments experienced fiscal crises and could no longer service their debts. Banks had lent to these governments and their condition was impaired by the value of the government bonds falling. The economies went into recession, which was aggravated by higher taxes and enhanced collection of taxes. Greece is the poster child for a financial and economic crisis begat by a fiscal crisis.

In some countries, the country’s banks engaged in imprudent lending to private firms – typically property developers and overextended homeowners. The banks became insolvent as the loans soured. Credit was curtailed and the economy went into recession. Then government revenue fell and a fiscal crisis ensued. A highly indebted private sector and irresponsible banking sector caused a fiscal crisis. Ireland and Spain exemplify this type of crisis.

Countries can experience banking crises without a fiscal crisis and vice-versa. When the two occur simultaneously, recessions tend to be deeper and prolonged. If there is also a currency crisis, the crisis deepens further. The Euro Zone has thus far escaped that.

There is much outrage over how the Cypriote crisis banking crisis was resolved. An example is Frederic Sautet’s recent post at Coordination Problem. Many were shocked that large depositors lost money in the resolution of two insolvent banks. Let us be clear on how and why that occurred.

First, the banks were insolvent. They had engaged in imprudent lending, particularly to the Greek government. They could not pay their creditors. Depositors are creditors. Second, the Cypriote government could not bailout the banks. The banking sector was outsized compared to the rest of the economy (the ratio of bank assets to GDP was 7.5 by one account). Small countries in which the banking sector is very large relative to the rest of the economy are at risk for banking crises. That was an important factor in both Ireland and Spain. (It was also the story in the earlier crisis in Iceland, which is outside the European Union.)

Third, the Cypriote government could not print money to bailout the banks because Cyprus is in the Eurozone. Therefore, the only alternative was for taxpayers in other countries, notably in Germany, to pay for a bailout of depositors at Cypriote banks. German (and other) taxpayers are tired of bailing out profligate banks and governments of others countries.

The depositors who lost money were uninsured depositors (deposits above €100,000). What do the critics of the resolution think uninsured means? Surely it means your money is at risk. True, in recent banking failures, governments have been reluctant to let even uninsured depositors lose money. But that was policy, not law.

A sudden regime change is always painful. Indications are that future bank bailouts in the EU may follow the Cypriote model. Bank depositors must understand that they are creditors of the bank. If they lend more than the amount insured, their money is at risk like that of other creditors.

The sad fact is that there is not enough money in the Eurozone to pay off all the debts (private and governmental) incurred in the zone. Households, firms, and governments have taken on more obligations than they can pay. Thus far, to its credit, the European Central Bank has been unwilling to engage in wholesale depreciation of the currency. That may come next. Likely, first there will be more bank failures and resolutions as has just happened in Cyprus.

Critics of the Cypriote bailout must explain what the alternative bailout policy might have been. And they must also explain why we should not be outraged at their alternative.