Cost of Eurogroup's Tactical Errors Will Outlive Cypriot Crisis

Europe is playing with fire. As the Cypriot crisis reached a breaking point last month, dealmaking with the Eurozone and International Monetary Fund exposed the Lilliputian country's insured depositors to potential losses. That arrangement was subsequently rejected by Cyprus' parliament, but the assurances that have followed have done little to restore public confidence.

Insured depositors are not sovereign bondholders. The former operate under the premise they face no risk. While such a guarantee may be qualified in the least developed economies, it should be inviolable in the context of the Eurozone. At least if stability across the currency union remains a policy goal. The IMF can say that Cyprus is a unique case, but the optics suggests a tactical error. The precedent has been set. In a pinch, depositors elsewhere know their savings accounts are on the table.

The possibility of contagion is real, even if a sense of calm has been restored over the last few days. Europe's anchors of stability have themselves to blame this time. The Dutch finance minister, who also currently serves as the head of the Eurogroup, said last week that the Cyprus deal … “represents a new template for resolving euro zone banking problems.” If that's taken to heart, the next turn for the worse in Spain, Portugal, or Italy could very well prompt a run on the banking system.

As of early April, the weight of Cyprus' bank losses has been shifted to accounts that exceed the guarantee. Following an abrupt and astonishing lapse into a cash and barter economy, banks in Cyprus have reopened with controls in place. But public trust in the banking system has been sundered. That should come as no surprise. The possibility that even the smallest savers might have faced an abrogation of the sovereign guarantee has shattered the credibility of the deposit insurance scheme.

Bailout weary Europeans, in Germany in particular, will argue that everyone should have to make sacrifices as part of an intervention. With or without a cull of bank deposits, they can rest assured that everyone will. The current bailout terms sound the death knell for Cyprus' prodigious financial industry. No Cypriot will escape making sacrifices as their real economy slides into severe and politically destabilizing recession.