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One has to commend President Anastasiades of Cyprus for his courage to write a letter to his European taskmasters explaining to them how the IMF-EU bailout program is destroying his country. However, now that his plea for easier loan terms has predictably fallen on deaf European ears, it is to be regretted that he appears resigned to allow Cyprus to become yet another country to be crucified on the euro cross for the benefit of the European banking system.
Leaving the euro would undoubtedly be a daunting decision for Cyprus that would not be without its risks. However, before summarily dismissing that idea, Mr. Anastasiades might want to consider the very high economic and social cost that Cyprus would bear by remaining bound to the euro mast. He might do so by reflecting on the five arguments listed below which underline how much more preferable it would be for Cyprus to leave the Euro now rather than to endure many years of economic depression and misery within the Euro straitjacket. This would especially seem to be the case considering that many years of economic hardship are in the end all too likely to force the country out of the Euro for want of political willingness to remain in an arrangement that offers little hope of economic recovery.
Reason 1: Severe budget austerity will not work: Cyprus is hardly the first European country to have been required to sign up to severe budget austerity in return for IMF-EU bailout funds. Greece, Ireland, and Portugal have all preceded Cyprus down that sorry road. Sadly, in each of those cases, severe budget austerity within a euro straitjacket has led to the deepest of economic depressions. And in each of those countries, after many years of economic contraction and very high unemployment, there is little sign of a meaningful economic recovery anytime soon.
It would be fanciful to think that Cyprus will be any more successful in avoiding many years of economic contraction than was a country like Greece where output has now declined by more than 20 percent over the past four years. Indeed, there is every reason to think that the economic decline that lies ahead for Cyprus will be deeper and swifter than that which occurred in Greece. For unlike Greece, Cyprus is being required to undertake severe budget adjustment at the very same time that the off-shore banking model on which the country’s past economic prosperity was largely based has now been destroyed.
If there is one lesson that Cyprus should have learnt from the experience of other countries in the European periphery, it is that excessive budget tightening within a euro straitjacket can lead to a vicious economic cycle without an end. A weaker economy undermines budget performance, which requires yet more austerity. Similarly a weaker economy undermines bank balance sheets which lead to greater credit restriction. And a weaker economy also undermines the very social and economic fabric of the country that is hardly conducive to a return of economic confidence.
Reason 2: Fundamental economic restructuring requires a flexible exchange rate: Prior to its economic crisis, the mainstay of the Cypriot economy was its off-shore banking system, which provided employment and generated substantial external earnings. That off-shore banking system has now effectively been dismantled at the insistence of the IMF and EU as part of Cyprus’ rescue package. It is difficult to see how Cyprus can possibly boost its tourist and export sectors to compensate for its severely impaired off-shore banking system without the benefits of exchange rate devaluation. And absent a big boost to its tourism and export sectors, it is difficult to see how Cyprus can avoid many years of the deepest of economic depressions and high unemployment.
Reason 3: Cyprus still enjoys favorable political conditions: When Cyprus eventually does leave the euro it will need to back the move to its own currency with sound budgetary and monetary policies if its economy is not to fall into an inflationary spiral. Delaying an early exit from the euro entails the very real risk that a prolonged economic depression and high unemployment will almost certainly erode the country’s political willingness to follow disciplined policies once the country is in the end forced to leave the euro. It would seem preferable to exit the euro now while the country still enjoys the political conditions to make the exit succeed.
Reason 4: Far-reaching capital controls are already in place: One of the key arguments made against a country choosing to leave the euro is that such a course would require state intervention in its banks and the application of far-reaching capital controls. This argument is hardly applicable to Cyprus’ current circumstances where the state has already been forced to intervene in the banks and where draconian capital controls are now firmly in place. By not leaving the euro now, Cyprus would appear to be accepting the costs of exiting the euro without deriving any of the benefits.
Reason 5: There are advantages to be the first mover: Cyprus is hardly the only weak link in the euro and it would almost certainly be forced out of the euro were there to be a Greek, Portuguese, or Italian exit from the euro arrangement. By choosing to be the first to leave, Cyprus could hope that it gets treated as a special case by the European community in an effort to allow for an orderly exit. One would think that such a course would be preferable to Cyprus being forced out in the midst of a generalized euro crisis.
In short, Mr. Anastasiades might do well to reflect on a well-known German saying that “an end with horror is better than a horror without an end.” By choosing to leave the euro now he would not be charting an easy course for his country. However, he would at least be offering the country the prospect that it will be spared from the many years of economic depression that remaining within the euro is bound to entail.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund’s Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.
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