Why Cyprus won’t leave the eurozone

If I were the president of Cyprus, knowing the little that I know right now, I would take the country out of the Eurozone. But that is not a no-brainer. There would be a lot of losers. Cyprus should leave the euro, but it won’t, because the losers outweigh the winners in the short run.

Who would be the losers from leaving the euro?

1. Savers with less than €100,000. Right now, their savings are untouched. True, they can’t move those savings off the island, but the chances are good that they will eventually. And the banks have reopened, even if cash withdrawals are limited.
2. Creditors. They would either be repaid in devalued Cypriot pounds or face the possibility of huge write-offs under a new super-lenient bankruptcy law.
3. The employed. “Say what?” you ask? Well, consider. My grandfather kept his job during the Great Depression. As a result, he made enough money to move from Crown Heights to the then suburban-paradise of Jamaica, Queens, plus a second house in Miami Beach. The reason was that deflation drove up the value of wages and assets for those who managed to hold on to them. I doubt that Cyprus is in for as punishing a deflation, but deflation it will be. Moreover, the Mexican and Argentine experience shows that one of the ways in which devaluation works its recovery magic is by falls in real wages. Argentine wages fell by almost a fifth in the two years after the devaluation. Cyprus imported 47% of its GDP in 2010, compared to only 12% in Argentina in 2000, the year before it left the American monetary union. It’s even higher than in Mexico, which imported 22% in 1994, before its big (and devastating) devaluation. Given the scale of imports, the fall in Cypriot real wages from devaluation is likely to be rather worse than in Argentina or Mexico.
4. Debtors to foreigners … possibly. There would be a legal nightmare if Cyprus reintroduced the pound. Locally-owed debts could be poundified, but foreign debts could not. Any attempt to do so would lead to a rash of lawsuits. I would not worry that reintroducing the pound would lead to Brussels throwing Cyprus out of the E.U. … but I would worry that forced poundification of foreign debts just might.

OK, so who wins?

1. The unemployed. Of course, the unemployed will have to grow to a rather large number for them to provide a big enough interest group to matter. There’s a reason Argentina didn’t devalue until 2001, despite three years of depression.
2. The soon-to-be-unemployed. OK … but the woman whose wages collapse and can no longer afford to send her daughter to the U.K. for university is not going to vote based on what would have happened. In a world like that, President Obama would have won re-election with LBJ-like margins. We do not live in that world.
3. Bankers. Yes, bankers! Both their debts and the liabilities will be poundified, at least if the Cypriots are a little bit smarter about it than the Argentines. (And even in Argentina, the courts plus politics eventually helped the banks out.) They will have a bigger problem with their non-deposit liabilities, but they are going to have that problem as the Cypriot economy collapses regardless. More importantly, the new Cypriot central bank will be able to print pounds in order to help the banks out.
4. The tourism industry. Cyprus has a population that’s barely twice that of Barbados; there’s no question that tourism could sustain a high-wage developed economy. The problem is that they would be betting on tourism in an environment in which the rest of Europe is either in or sliding into recession. The tourism boom could take rather longer to get going than the post-1994 manufacturing boom in Mexico or the post-2001 agricultural boom in Argentina.
5. Debtors to foreigners … possibly. If the Cypriot government is willing to protect them from creditors (all creditors, foreign and domestic, in order to remain in the E.U.) or bail them out via cheap pound loans, then they could do surprisingly well out of a situation that one would otherwise expect should be disastrous;
6. Other debtors: inflation is good for debtors.

How will this political logic look by the 2018 election? Well, I’m pretty sure that it will look like staying in the euro was a bad decision. In that sense, I would advise President Anastasiades to leave the euro now and bet on re-election on the wave of a giant economic boom by the time the next presidential election rolls around.

The problem is that it is not at all clear that such a move will look great by the time of the next legislative election in 2016. There are a lot of short-term losers, and they are politically powerful.

In fact, given the opposition, a new currency may be impossible. The president of Cyprus is powerful, but he cannot unilaterally introduce a new currency. There would have to be wide support for such a move. The problem is that most of the soon-to-be-unemployed won’t give it, the bankers are unlikely to act in their self-interest (this is oddly true of American bankers, I should add), and those who owe debts to foreigners can only be appeased by radical changes in Cypriot bankruptcy law. (It is currently very strict; e.g., creditor-friendly.)

While leaving the euro looks like a clear decision at first glance — two-thirds of Cypriots support it! — the politics rapidly gets blurry by the second and third look. Argentina left the American monetary union after a punishing depression had reduced the economy to barter; Mexico’s president could unilaterally devalue (and pretty much had no other option by that point). Leaving the euro would almost certainly lead to a richer and stabler Cyprus by 2018 … but the above analysis, superficial as it is, makes me think that you can’t get there from here.

Cyprus will have a long and grinding depression, but it will not (unlike Argentina) be reduced to barter because the ECB will provide just enough liquidity to insure that does not happen. Things will get awful, but probably never quite awful enough to get the government to take the logical step. It’s a tragedy for the Cypriot people, but an entirely understandable one.