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Cyprus Will Lead The Eurozone Prison Break

"Cyprus's economy will now go through a long and painful period of adjustment. But then it will pay back the loan when it is on a solid economic foundation."
---Wolfgang Schaeuble, German finance minister

Anglophone economists have been advocating euro exit for the peripheral eurozone economies since the crisis began three years ago. They have recommended exit because “internal devaluation” is vastly more destructive than external devaluation, and because these countries need inflation, not deflation. The counter-argument from Europe has been that exit would cause chaos plus the threatened loss of official flows. Countries cut off from the EU’s largesse would supposedly be forced to balance their current accounts overnight. It is also argued that, as the new currency depreciates, external debt denominated in euros would grow in both nominal and real terms.

The European arguments against exit are self-serving: creditors never advise their clients to walk away from their debts. The more debt that Europe can pile onto these countries, the more likely that the flows will reverse, and the greater the advantages of default. All of the peripherals should have left the euro when the crisis began, before incurring enormous debts and inflicting penury on themselves for no reason. In the end, all of the peripherals will be forced by their indebtedness to leave the euro, unless the ECB is willing to open the monetary floodgates immediately. All of the unemployment and national bankruptcy being incurred now is waste. In the end, the peripherals will have to suffer both the pain of both internal devaluation and of euro exit and default.

The wanton destructiveness of this process is deeply disheartening. Millions of lives are being ruined on the altar of a half-baked idea, the notion of Europe as a "country". It is a bit ironic that capitalist Europe achieved final victory over communism, only to stumble twenty years later due to internal contradictions. The internal contradiction is the Protestant belief that all countries need hard currencies, or should have them anyway even if they don’t need them.

Creditors dislike bankruptcy, and do what they can to prevent it, including lending the borrower money to pay interest (e.g., Latin America in the 1980’s). They also threaten the borrower with dire consequences if he should default. They do not want Debtor #1 to see Debtor #2 walk away from his debts and begin a new life. Instead, they will try to accommodate Debtor #1 so that he won’t go bankrupt. Creditors do not do these things to help the debtor; they do it to preserve their principal.

The endgame for the peripherals will come when the pain of perpetual depression exceeds the fear of exit. For some countries, that day will come in a year or two. For one country that day has arrived, namely Cyprus. Until Cyprus, the word from Europe was “if you exit, we’ll burn your crops and your barn”. But for Cyprus, Europe has already burned down their crops and their barn. There is nothing left to save, and thus no reason to hand another dime to the extortionists.

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The Cypriots are in the midst of a national catastrophe that is going to force them to make hard choices in the very near future. It won’t take long for them to get out their calculators and do the math. They have two options: (1) stay in the eurozone carrying an oppressive debt burden into eternity; or (2) exit the euro, default on their debt, and restore monetary sovereignty. Since they are going to have to default on their debt anyway, they may as well do it now and get the simultaneous benefit of devaluation.

The Cyprus situation is similar to Argentina, but not exactly. Argentina escaped an unsustainable debt burden by unilaterally repudiating its debt. The country has done much better as a result, but remains a financial outlaw, pursued by angry creditors around the world. Cyprus does not have to default in such a ham-fisted way.

First of all, most of Cyprus’s debt is to Europe, not private bondholders. Cyprus can reduce this debt in the time-honored debtor tradition: “Give me a break or you'll get nothing”. The troika won’t have much leverage in this negotiation, unless it plans to send its gunboats to Limassol. Bondholders can be handled in a similar fashion (see: Greece). Any debt incurred under Cypriot law can be redenominated and/or rescheduled by fiat. This is all eminently do-able.

The reason why Europe “rescued” Cyprus was to prevent it from escaping from the eurozone and setting a bad example for the other inmates. Once Cyprus escapes and gets away with it, Greece will follow in short order. The Portuguese are “good Europeans”, but regional solidarity gets old quickly when you’re starving. Portugal will exit once someone else has paved the way. (After all, Brussels can't declare war on half of Europe.)

One would hope that, before the rot seeps too deeply into the heart of the eurozone (e.g., Spain and Italy), the ECB would see the light and reflate the continent, thus preventing Armageddon. Right now, it's an even bet.