The European economic crisis has taken different forms in different places, and Cyprus is the latest country to face the prospect of financial ruin. Overextended banks in Cyprus are teetering on the brink of failure for issuing loans they cannot repay, which has prompted the tiny Mediterranean country, a member of the European Union, to turn to Brussels for help. Late Sunday, the European Union and Cypriot president announced new terms for a bailout that would provide the infusion of cash necessary to prevent bankruptcies in Cyprus' banking sector and, more important, prevent a banking panic from spreading to the rest of Europe.
What makes this crisis different from the previous bailouts for Greece, Ireland or elsewhere are the conditions Brussels has attached for its assistance. Due to circumstances unique to Cyprus, namely the questionable origin of a large chunk of the deposits in its now-stricken banking sector and that sector's small size relative to the overall European economy, the European Union, led by Germany, has taken a harder line with the country. Cyprus has few sources of capital besides its capacity as a banking shelter, so Brussels required that the country raise part of the necessary funds from its own banking sector -- possibly by seizing money from certain bank deposits and putting it toward the bailout fund. The proposal has not yet been approved, but if enacted it would undermine a formerly sacred principle of banking in most industrial nations -- the security of deposits -- setting a new and possibly destabilizing precedent in Europe.
For years before the crisis, Cyprus promoted itself as an offshore financial center by creating a tax structure and banking rules that made depositing money in the country attractive to foreigners. As a result, Cyprus' financial sector grew to dwarf the rest of the Cypriot economy, accounting for about eight times the country's annual gross domestic product and employing a substantial portion of the nation's work force. A side effect of this strategy, however, was that if the financial sector experienced problems, the rest of the domestic economy would not be big enough to stabilize the banks without outside help.
Europe's economic crisis spawned precisely those sorts of problems for the Cypriot banking sector. This was not just a concern for Cyprus, though. Even though Cyprus' banking sector is tiny relative to the rest of Europe's, one Cypriot bank defaulting on what it owed other banks could put the whole European banking system in question, and the last thing the European Union needs now is a crisis of confidence in its banks.
The Cypriots were facing chaos if their banks failed because the insurance system was insufficient to cover the claims of depositors. For its part, the European Union could not risk the financial contagion. But Brussels could not simply bail out the entire banking system, both because of the precedent it would set and because the political support for a total bailout wasn't there. This was particularly the case for Germany, which would carry much of the financial burden and is preparing for elections in September 2013 before an electorate that is increasingly hostile to bailouts.
Even though the German public may oppose the bailouts, it benefits immensely from what those bailouts preserve. As I have pointed out many times, Germany is heavily dependent on exports and the European Union is critical to those exports as a free trade zone. Although Germany also imports a great deal from the rest of the bloc, a break in the free trade zone would be catastrophic for the German economy. If all imports were cut along with exports, Germany would still be devastated because what it produces and exports and what it imports are very different things. Germany could not absorb all its production and would experience massive unemployment.