Felix Salmon

Megan Greene has a great column on Cyprus and the euro today. In short, there are costs and benefits to leaving the euro — but the costs are going to be borne anyway, which means that at the margin, devaluation is likely to be good for the country.

Among the greatest costs of any euro-area exit would be bank defaults on their liabilities, capital controls and a sovereign default. Cyprus has already experienced the first two and will most likely see the latter in the next year or two if it stays in the euro area.

So if Cyprus is going to incur some of the worst costs of abandoning the euro anyhow, it might as well print its own currency and benefit from a devaluation and the immediate boost in competitiveness that would follow.

This is perfectly logical. But — you knew there was going to be a but — there are two big complications.

Firstly, leaving the euro is an expensive proposition, and Cyprus doesn’t have any money: it’s already selling off its gold reserves to help recapitalize its banks. Cyprus would be insolvent, with massive new debts to the ECB; it would also have massive liquidity problems, with no obvious way of paying for the enormous quantities of foreign imports all island nations require. As a result, there’s only one way for Cyprus to exit and devalue without risking power cuts, food shortages, and general chaos: it would need to borrow even more money than it has done already. Which is not going to be easy, given that the rest of the world has made it very clear that it’s pretty much maxed out, in terms of loans to Cyprus.

How could Cyprus persuade the EU and the IMF to lend it the extra money it would need for a semi-orderly devaluation? Threatening default wouldn’t work, since it’s basically impossible for Cyprus to devalue without defaulting. Alternatively it could threaten to run into the arms of Russia, but that would be a very high-risk strategy indeed.

And then there’s the other big complication: while a Cypriot exit would probably be good for Cyprus, it would be very bad for the rest of the eurozone, since it would be a clear precedent showing that exiting the euro is possible after all. The result would be further capital flight from the eurozone periphery towards the center, and a general feeling that the multi-year project of trying to remove tail risk from the euro had failed spectacularly. There’s no way that any country leaving the euro could possibly be good for the rest of the currency union — even if that country were as small as Cyprus.

Greene’s conclusion, then, is absolutely right: if the troika won’t help Cyprus exit the euro — and there’s absolutely no indication that it will — then “Cypriots really are stuck”. The government would have no recourse, at that point. Individual citizens, on the other hand, could still take advantage of the relatively free labor mobility within the EU, and move to another European country where prospects are brighter.

Is that likely? Even within countries, people in poorer areas (the north of England, the south of Italy, the east of Germany) rarely move en masse to richer areas with greater potential; big movements between countries are rarer still. But the bigger the osmotic gradient between two economies, the greater the flow of human resources into the wealthier nation. And Cyprus has more than its fair share of the most mobile population in Europe: relatively young and well-educated people with good language skills. If their future is brighter in the UK than it is in Cyprus, they’ll move there.

Cyprus can implement capital controls, but it can’t implement emigration controls. Even if it does leave the euro, a lot of its most talented professionals will leave; if it doesn’t, and falls instead into what Greene calls “an endless spiral of austerity and recession”, the brain drain will make Latvia’s look modest. The cost of joining the euro, for Cyprus, will be no less than a hollowing out of its population, along with its economic and demographic future. Let’s hope that it manages to find a way to exit, somehow.

A small country which has adopted a major global currency finds itself with massive debts and insolvent banks. Its only real hope is that it controls areas rich in hydrocarbons; the problem is that it has neither the wealth nor the expertise to exploit those hydrocarbons on its own. The result: it ends up essentially selling itself to an omnivorous global superpower which is interested only in access to resources rather than in domestic economic growth and prosperity.

This is the narrative which might well end up playing out in Cyprus. The local population is so unhappy with the euro that they’re seriously looking to bitcoins as an alternative, despite the fact that there is no real bitcoin economy, and insofar as there is one, it’s inherently deflationary. Much of the country’s political, economic, and religious elite is seriously talking about leaving the euro. If they decided to do that, Cyprus would probably become even more controlled by Russia than it is already — especially given that Gazprom is by far the most obvious candidate when it comes to finding a partner which can exploit Cyprus’s natural gas reserves.

If you want to see an example of what this story looks like in practice, just take a look at Ecuador, which adopted the dollar as its national currency back in 2000. Since then, it has had a brutal debt restructuring, causing most foreigners to give up on putting their money into the country. Predictably, China stepped into the vacuum, and is now by far Ecuador’s largest source of funds.

The latest development is that Ecuador is probably going to sell about three million hectares of pristine Amazonian rainforest — that’s about 12% of the total area of Ecuador — to Chinese oil companies. Ecuador might not be drilling in Yasuni — yet — but this new parcel is right next door, and if the Chinese come in to drill for oil there, the effects on Yasuni can’t possibly be positive.

Ecuador’s indigenous population is up in arms, but is effectively powerless in the face of China’s tsunami of cash. For its part, China has no real interest in Ecuadorean economic growth or the wellbeing of its people; it just wants to control Ecuador’s natural resources, and is willing to pay many billions of dollars to do so.

If Cyprus once again restructures its debt and/or leaves the euro, could we end up in a world where Russia controls Cyprus to anywhere near the degree that China controls Ecuador? The answer to that has to be yes, given Russia’s imperial ambitions and the degree to which Russia’s wealth dwarfs anything in Cyprus right now. Cyprus has already announced that its harsh capital controls are going to be in place for at least a month; realistically, they’re likely to stay much longer than that. So long as they remain in place as the Cypriot economy suffers the deepest recession in the history of the eurozone, it’s going to be very difficult to persuade Cypriot voters to accept the status quo.

The EU, then, should be thinking very hard about how it can bring Cyprus back into the European fold. There are as many differences between Cyprus and Ecuador as there are similarities — but still, Ecuador is a sobering reminder that rich, resource-hungry powers really can end up essentially taking over a nominally sovereign democratic nation. For many years, the EU looked down at emerging-market countries suffering major crises, with an attitude of “it could never happen here”. Well, we’ve now learned, the hard way, that big crises can happen in the EU. The lesson must surely be that nothing is unthinkable.

If a gaffe is what happens when a politician accidentally tells the truth, what’s the word for when a politician deliberately tells the truth? Dutch finance minister Jeroen Dijsselbloem, the current head of the Eurogroup, held a formal, on-the-record joint interview with Reuters and the FT today, saying that the messy and chaotic Cyprus solution is a model for future bailouts.

Those comments are now being walked back, because it’s generally not a good idea for high-ranking policymakers to say the kind of things which could precipitate bank runs across much of the Eurozone. But that doesn’t mean Dijsselbloem’s initial comments weren’t true; indeed, it’s notable that no one’s denying them outright.

Dijsselbloem’s interview can be summed up simply: we’re not bailing out banks any more. Instead, we’re going to let them fail.

When a European bank runs into difficulties in the future, under this view, the EU is not going to help bail it out. Instead, it will go down a list: the bank’s executives come first, then its shareholders, then its bondholders, and finally its uninsured depositors. All of them will take losses before the national or European authorities step in with bailout money.

In principle, this makes perfect sense. Given the choice between Ireland and Iceland — between guaranteeing all bank creditors, on the one hand, or just letting the banks fail, on the other — the latter seems to inflict pain where it’s warranted, on irresponsible lenders, including foreign lenders, rather than on the country as a whole.

What’s more, what you might call the Dijsselbloem Principle does help to remind people that depositors are creditors, and that when you deposit money with a bank, you’re lending that money to an entity which might not pay you back. Deposit insurance is basically a government guarantee backstopping that loan: if the bank can’t pay you back, the government will. But deposit insurance is only there for insured depositor — it can’t mission-creep its way into backstopping uninsured depositors and even the bank itself.

Such a principle would have consequences, of course, both intended and unintended. Paul Murphy provides the requisite parade of horribles:

It’s a direct call to depositors across the eurozone — retail and corporate alike — to move cash now and spread it across a portfolio of the largest available banks. It’s direct advice to dump bank debt. And it’s a direct invitation to speculate that the EFSF, the ESM, and the rest of the alphabetic bailout soup is going to be discarded in favour of calling on depositors’ money across the Continent.

Much more unnerving than the potential future consequences of the new policy, however, was the immediate reaction of bank stocks to Dijsselbloem’s comments: the Euro Stoxx Banks index fell almost 4% on his comments.

Which brings up what you might call the Other Dijsselbloem Principle: you can do anything you like, just so long as it doesn’t spook the markets. This was the crucially-important background to the negotiations between Cyprus and the EU: the Europeans were emboldened to be tough on Cyprus by the fact that global markets seemed utterly unconcerned about what was going on in an economy which accounts for about 0.15% of European GDP, and shrinking.

After all, anything that the Eurogroup did in Cyprus would have set a dangerous precedent somehow, even if they had simply capitulated and agreed to a full €17 billion bailout of both the sovereign and the banks. We still don’t know what kind of capital controls Cyprus might impose on its banks when they reopen for business in the morning: those controls ensure that a Cypriot euro is not fungible with a German euro, and as such represent Cyprus’s first steps towards fully-fledged exit from the eurozone.

Indeed, for all that Dijsselbloem’s comments caused the most immediate market reaction, traders with a slightly longer-term time horizon would do well to pay attention to the real powers in Cyprus: people like  lawmaker Nicholas Papadopoulos, Nobel laureate Christopher Pissarides, and even Archbishop Chrysostomos II, the head of the Cypriot Orthodox Church. All of them are talking openly about exiting the eurozone — the one degree of freedom which Cyprus really has, now that the Troika has imposed austerity, bank resolution, and everything else onto the island from above.

Think about it this way: exiting the euro is a bit like the US hitting its debt ceiling and defaulting on its Treasury bills. Both of them are meant to be unthinkable, impossible. But both of them are thought about at length, and entirely possible in theory. What’s more, the opportunity is always there. No country has exited the euro in the past, just as the Treasury has not defaulted in the past. But even if the probability at any given point in time is small, over a long enough time horizon it still grows. And right now, the probability of a country exiting the euro is not small: no country has ever been more likely to exit than Cyprus is right now.

Dijsselbloem’s interview today was undoubtedly a prime piece of political incompetence: there’s no reason at all for anybody in the Eurogroup to be drawing broader lessons from Cyprus at this point. The market can speculate about the Cypriot precedent all it likes; it behooves no politician to to be clear about what they think it means, least of all the Eurogroup president. Maybe, in a few months’ time, when the Cyprus chaos has died down, the EU could start putting out extremely long and dry papers about what has been learned from Cyprus, along with a detailed look at the costs and benefits of letting banks fail rather than bailing them out. But if you’re making policy on the fly in Cyprus, the last thing you want to do is turn that cobbled-together precedent into something semi-binding on the rest of the continent — whatever the policy might be.

Still, the toothpaste is out of the tube now, and the traders selling off bank shares were acting entirely rationally. The chances of European banks being allowed to fail are higher now than they were pre-Cyprus. As a result, we should expect uninsured deposits to continue to flow from the periphery of Europe towards the center. Which in turn means extra pressure on Italian and Spanish banks, just when it’s least needed.

This was not a good weekend for Russian billionaires. First, Boris Berezovsky was found dead at his English country estate. Now, all the uninsured depositors (read: Russian plutocrats) at Cyprus’s two largest banks are going to be hit much, much harder than they feared they might be when the Cyprus crisis first erupted last week.

Back then — a long, long week ago — Cypriot president Nicos Anastasiades stood firm: there was no way he would allow uninsured depositors to lose more than 10% of their money. What a difference a week makes: now, if your uninsured deposits are at the Bank of Cyprus, you’re probably going to lose about 40% And if they’re at Laiki, you’re going to lose everything.

The agreement between the Cypriot government and the Troika of the EU, IMF, and ECB is a bold and brutal geopolitical power-play. There might be language in the official communiqué about how “The Eurogroup looks forward to an agreement between Cyprus and the Russian Federation on a financial contribution”, but given the billions of euros that Russians are being forced to contribute unwillingly, the chances that they’ll happily throw a bit more money into the pot have to be tiny.

In the Europe vs Russia poker game, the Europeans have played the most aggressive move they can, essentially forcing Russian depositors to contribute maximally to the bailout against their will. If this is how the game ends, it’s an unambiguous loss for Russia, and a win for the EU. For one thing, there won’t be any capital controls: that’s a good thing. (Some deposits at Bank of Cyprus will be frozen, which is a kind of capital control, but there aren’t corralito-style barriers on the general movement of euros in and out of the country.) On top of that, public markets have been left unruffled: there’s been no panic on Europe’s bolsas, partly because the biggest hit has been taken by private Russian citizens.

Much more importantly, the two main vectors of contagion — hitting insured deposits, and exiting the euro — have been avoided. And most elegantly of all, from the Troika’s point of view, the whole thing has been constructed under existing bank-resolution authorities, which means that no vote needs to be put to the Cypriot parliament, and therefore no amount of Russian pressure can veto the deal in Nicosia.

Of course, the game does not end here. It’s unlikely that Russia will appear bearing a better deal at some point in the next 24 hours, but the hit to Cyprus’s GDP is going to be so enormous that staying in the euro over the long term, absent another round or two of massive debt relief, is going to be extremely difficult. The deal as constructed is, in Pawelmorski’s wonderful phrase, “Iceland without the fish”: Cyprus, as Iceland did before it, is letting its banks fail, since they’re too big for the government to bail out. But Iceland has other industries besides banking — and, more importantly, has a floating currency as well, which by weakening can make those industries more competitive.

In order to truly become Iceland, then, Cyprus is going to need to devalue and default. If it doesn’t, then it will live unhappily under the yoke of Europe-imposed austerity until such a time as the parliament revolts, the austerity measures are revoked, and the island drops out of the euro, and probably out of the EU as well. Cyprus’s economy is going to suffer greatly over the next few years, and its citizens are going to blame Europe for their woes; it’s entirely possible that they will voluntarily leave the euro, if the alternative is negative economic growth as far as the eye can see, along with a massively overvalued currency. If and when those rumblings start appearing, expect the Russians to start being extremely nice to the Cypriots all over again.

Meanwhile, the resolution of Laiki is going to give the world a very real example of what happens when a too-big-to-fail bank is allowed to fail. Laiki is small by global standards, but very large by comparison with Cyprus’s GDP. If Cyprus can survive Laiki’s collapse, then maybe — just maybe — the world could cope with the “resolution” of a big bank like Citigroup. But that’s a very big “if”. More likely, the costs to Cyprus of allowing Laiki to fail will be enormous, both politically and economically. And 800,000 Cypriots will for years to come be paying the price of what Mohamed El-Erian elegantly calls “bailout fatigue”.

Paul Murphy, watching Cypriot finance Minister Michael Sarris returning empty-handed from Moscow, says that “Medvedev and co could not have played a worse hand during this crisis — and it’s not immediately clear why”. His point is that the most likely outcome right now — he calls it “popping the red pill” — is that big depositors at Laiki Bank (read: rich Russians) are likely to lose some 40% of their money. Since that will make Russia very unhappy, why is Russia doing nothing to prevent it?

I don’t pretend to understand Russian politics, but this move seems to me to be a classic high-risk, high-aggression play; think of Medvedev as a geopolitical hedge-fund manager or poker player, and it begins to make a bit more sense.

Firstly, it’s worth noting that Russia is actually moving backwards on the amount of help it’s likely to extend to Cyprus. When the bailout plan was first announced, it included Russia extending its existing €2.5 billion loan to the country by five years, as well as reducing that loan’s interest rate. Now, Russia is refusing to agree even to that.

More generally, Russia is taking an absolutist stance with respect to Cyprus. No, we won’t restructure the money you owe us. No, we won’t buy a bank off you. No, we aren’t interested in your natural-gas reserves. And underlying it all, of course, an unspoken — and all the more powerful for being unspoken — physical threat to any Cypriot who causes powerful Russians to lose billions of euros.

Why would Russia be acting this way towards Cyprus? The obvious answer is that Russia knows exactly who’s sitting around this poker table: it’s not Cyprus that they’re playing, it’s the EU. If Russia were to enter into good-faith negotiations with Cyprus right now, that would help the EU, by reducing the amount of EU support that the island nation needs. Moreover, any deal that Russia made with Cyprus could be vetoed by Germany, or the Eurogroup, or the ECB, or even possibly the IMF. Russia is too big and too important to try to do deals which could be forcibly unraveled on a German finance minister’s whim.

And while we have a pretty good idea what the Russian prime minister is saying to Sarris in Moscow, we have a much less clear idea of what other Russians are saying to Cypriot lawmakers in Nicosia. The Cypriot capital is reportedly full of mysterious Russians right now, and it might not be all that hard for them to nobble a vote in parliament — especially given that just about any vote is going to be massively unpopular with voters. Remember that if the Cypriot parliament does nothing, then Cyprus collapses; we’re going to need a big show of political unity to prevent that. And so far, the only political unity we’ve seen has been against the bailout, not for it.

Which brings me to the blue pill, as described by Murphy:

Cyprus now has a binary choice: become a gimp state for Russian gangsta finance, or turn fully towards Europe, close down much of its shady banking sector and rebuild its economy on something more sustainable.

Murphy says it’s “obvious” which choice Cyprus should take. But it’s probably much less obvious to Cyprus’s parliament. As Paul Krugman says, Cyprus is very attached to its shady banking sector. And what exactly does Murphy have in mind when he talks about an economy based “on something more sustainable”? Natural gas? Well, given Cypriot national ties, it’s easy to see which company has pole position in terms of getting that mandate: Gazprom.

All of which is to say that there’s a real possibility — maybe not an outright probability, but certainly a good chance — that Cyprus will end up taking the blue pill rather than the red pill, and becoming a Russian client state, either inside or outside the euro. After all, Cyprus is a Eurogroup client state right now, and has wound up in this sorry place as a result. If it pops the red pill, it will have essentially no autonomy for the foreseeable future in any case.

It’s also easy to imagine that Putin’s Russia views its relations with the EU as something of a zero-sum game. Russia also has a more than 150-year obsession with acquiring influence, if not outright control, over warm-water ports in Southern Europe. Looked at that way, the loss of Cyprus from the EU to Russia would be a clear loss to the EU and a clear win for Russia.

Which, in turn, might explain why Russia is doing absolutely nothing which might help the EU. It’s making a risky and aggressive move to essentially seize Cyprus from the hands of Europe, and to gain an important geopolitical foothold in the eurozone. The downside to that move is that if Cyprus pops the red pill, then a lot of Russians, especially the ones with deposits at Laiki, could lose a lot of money. But even if that does happen, Russia will be waiting patiently on the sidelines, with a lot of new money if needed, ready to snap up Cypriot assets at fire-sale prices.

There’s no doubt that the best outcome for Cyprus, and for the EU, would be for Russia to extend its help now, before Cyprus’s banks reopen on Tuesday. But Russia doesn’t want what’s best for Cyprus, or for the EU: Russia wants what’s best for Russia. And the way it’s acting reminds me of nothing so much as a classic Wall Street bear raid, designed to drive down the price of something you want to be able to pick up very, very cheap. What’s more, it might even work.

When it comes to financial negotiation, lenders nearly always have more power than borrowers — and the smaller the borrower, the more that’s true. Which is why Cyprus’s rejection of the EU bailout proposal was always dangerous. If they couldn’t come up with a Plan B, then there was always a risk of the worst-case scenario as spelled out by Cypriot president Nicos Anastasiades: the ECB would stop propping up Cyprus’s banks, which would immediately fail, causing 8,000 families to lose their income, 60% losses for bank depositors, bankruptcy for thousands of small Cypriot businesses, and probably (although Anastasiades didn’t spell this out explicitly) exit from the euro.

Well, now the ECB has brought Cyprus one step closer to Anastasiades’s “catastrophic scenario”: it has said that absent an EU/IMF deal which can recapitalize Cyprus’s banks, it’s going to stop lending to Cyprus on Monday.

Politically speaking, this places everybody concerned in a really tough position. The Cypriots aren’t getting anywhere with the Russians, who in any case can’t deliver an EU/IMF deal on their own. And the Eurocrats seem to be losing patience too:

The European Commission said Wednesday it was now up to Cyprus to put forward an alternative rescue plan after its lawmakers voted down a proposed bail-out package agreed by the Mediterranean island and its euro-zone partners last Saturday.

“It is now for the Cypriot authorities to offer an alternative scenario respective of the debt sustainability criteria and of the financing parameters,” Olivier Bailly, a commission spokesman said… “The ball is now in Cyprus’ court,” Mr Bailly told reporters in Brussels.

The problem with this is that the EU has two big conditions before it will sign on to any Cypriot plan. The first is clear and pretty much accepted by all: the EU and IMF will lend no more than €10 billion. But the second is actually more problematic: the stated reason why Europe won’t lend more than €10 billion is that Europe refuses to allow Cyprus’s debt level rise above a certain level.

As a result, even if Cyprus gets its €5 billion loan from Moscow, that wouldn’t actually help: in the eyes of Brussels, you don’t solve a debt problem by managing to find more debt. Similarly, borrowing billions of dollars from Cypriot pension funds wouldn’t help much either. The EU position is clear: we’ll give you the maximum amount of debt that you can handle. The extra billions need to be in the form of cash, which never needs to be repaid; the money can’t come in the form of loans.

So long as the EU sticks hard to that principle, Cyprus would seem to have precious few options; certainly the Buchheit-Gulati option wouldn’t help, since, as Joseph Cotterill notes, it keeps Cypriot liabilities at an unacceptably-elevated level. (Unacceptable to the EU, that is, and they’re the people who matter here.)

Cypriot negotiators have lots of perfectly sensible things they can tell the European purse-string holders about why this obsesssion with debt sustainability is silly. They can point to future natural-gas revenues, for instance, which give Cyprus the potential ability to pay of debts which seem huge right now. They can also point to the denominator here: if failure to reach a deal results in GDP collapsing, then the debt-to-GDP ratio will soar even if the debt level doesn’t rise at all. But the Europeans aren’t acting like impartial judges: by all indications, they’ve made up their mind.

Which leaves Cyprus in a very, very tough position. It can accept the idea of taxing bank deposits — or it can find itself tossed unceremoniously into the Mediterranean, left to fend for itself. Essentially, the EU is telling Cyprus that it can come up with any plan it likes, so long as the plan involves nothing but fiddling around with the Breakingviews deposit-tax calculator. You want to preserve all insured deposits? Fine, raise the tax on uninsured deposits to something over 15%.

Such a plan would mark the end of Cyprus as an offshore banking sector — but then again, so would the alternative. Cyprus’s banks are insolvent, thanks to the haircut they were forced to take on their Greek government bonds. And so if the island wants any kind of banking system at all, it is going to need to be able to continue to draw on emergency assistance from the ECB. Which means taxing deposits and generally doing as it is told by the EU.

But there’s a niggling problem here: Cyprus is a sovereign nation, and nothing is going to happen unless and until a law is passed by the Cypriot parliament — which has already rejected a deposit tax once, and which doesn’t seem any closer to accepting such a thing now.

Paul Krugman has a great post today on what he calls “the Sum of All FUBAR”: all the different things which have gone wrong in the past, and which are certain to get worse in the future, with respect to Cyprus. But Peter Coy sums the whole thing up best:

In retrospect, most or all of this could have been avoided if Cypriot banks had been prevented from lending so heavily to Greece. Once it was clear that the Central Bank of Cyprus was underregulating, the European Central Bank should have made noise, even though at the time it lacked authority to dictate terms. When the halloumi hit the fan, the EU, ECB, and IMF should have stood by Cyprus unconditionally. The time for tough love is before the crisis, not during it.

In other words, the only real solution to this crisis is for the EU to go back in time and stop it from happening in the first place. And the next-best solution would be for the EU to stop being so self-defeatingly stubborn on debt ratios. But if that doesn’t happen, the Cypriot parliament is going to face an unbelievably tough vote at some point in the next few days. Will they essentially cede their sovereignty to unelected Eurocrats, and rubber-stamp a deal which looks very similar to the one they’ve already rejected once? Or, standing on principle, will they consign themselves to utter chaos and a very high probability of leaving the Eurozone altogether? Such decisions are not always made rationally. Which means that if I were Joe Weisenthal, I’d be pretty worried right now about losing my $1,000.

Cyprus has said όχι to the idea of taxing deposits: good for them. And the parliament did so decisively, as well: 36 “no” votes, 19 abstentions, and zero “yes” votes. Even the president, who initially said that Cyprus had no choice but to say yes, was already moving on to Plan B before the vote was even taken, although no one yet is entirely clear what exactly Plan B entails.

One very big hint comes from the fact that the Cypriot finance minister, Michael Sarris, is in Moscow today (where he’s denying via text message reports that he has resigned). Russia accounts for the lion’s share of Cyprus’s uninsured deposits, and president Vladimir Putin has said that even a 9.9% tax on those deposits would be “unjust, unprofessional and dangerous”. Given that the only way that Cypriot president Nicos Anastasiades kept the tax to below 10% was by taxing the insured depositors at an unacceptable 6.75%, there is obviously a lot of appetite within Russia to help Cyprus find a way out of this mess.

One way to do that would be for Gazprom, the Russian energy giant, to spend a few billion euros on rights to Cyprus’s natural gas resources; another would be for the Russians to buy a bank or two, leaving Cyprus to raid local pension schemes for extra liquidity until natural-gas revenues come on stream. Or, of course, there’s always the Buchheit-Gulati option. The thing they all have in common is the idea that they’re basically trying to provide a bridge to the point at which Cyprus starts getting lots of money from its natural gas. Of course, the gas might not exist at all, or it might take a decade before it actually starts seeing revenues, so there’s risk here. But the point is that in Cyprus, uniquely, kicking the can down the road actually makes sense: if you get far enough down the road, there’s a real chance that everybody could end up being paid off in full, or making a substantial profit.

It’s not clear that Greece’s parliament will grok the distinction, however, which makes this particular game very dangerous for the Eurogroup. For the time being, the EU and IMF — and, crucially, the ECB — are keeping the lines open to Nicosia: the idea seems to be that so long as they don’t need to cough up any more than the €10 billion they’ve already agreed to, they’ll let Cyprus find the balance of the needed cash any way it wants. But here’s the rub: if Cyprus gets to reject the Troika and largely set its own terms, then everybody else (read: the Greek parliament) will want to be able to do that as well. And no one in Europe’s centers of power really wants the Mediterranean periphery getting too uppity.

The best-case scenario here is that the vote by the Cypriot parliament is a “phoney war”, in Dan Davies’s words: “A vote on which the government abstains is like opening with two hearts at bridge. It’s a bidding convention, not a serious plan.” Cyprus and the EU will go back for another round of negotiations, with Cyprus trying to front that it has a great offer from the Russians, and the two sides will come to a compromise which doesn’t involve taxing insured depositors. The banks will then reopen, the Russians will pull a large chunk of their remaining money out of the country, the ECB will provide all the liquidity that the Cypriot banks need, and Cyprus will muddle through in an austere kind of way.

The worst-case scenario — call it #CypriOut — is that talks just break down entirely, with no plan acceptable to both the Eurogroup and the Cypriot parliament, while the Russians ultimately decide that they don’t want to throw good money after bad. In that event, Cyprus ends up with a chaotic default and devaluation — think Argentina 2002, only on an island which is already fractured along intractable ethnic lines.

The cost of CypriOut to the ECB and to Europe as a whole would be substantial, both in euros and in precedent. If you think that taxing deposits is a bad precedent, just wait until you see what happens when the world learns that a country can leave the eurozone after all. So a lot of people are going to spend a lot of effort trying to avoid it. And judging by recent European history, some last-minute deal will manage to get cobbled together somehow. But this whole situation is horribly messy — it reminds me of the Argentine political chaos in March 2001, a few months before the country finally defaulted.

The big problem here is that there’s no overarching strategy on the part of the EU. An interviewer from Greek TV asked me yesterday whether the agreement with Cyprus represented an important change in the Eurogroup’s attitude towards peripheral countries. I had to say that it didn’t, just because that would imply that the Eurogroup has an attitude towards peripheral countries, which can change. Instead, it’s all tactic and no strategy, and the tactic is a dreadful one: wait until the last possible minute, and then do whatever’s most politically expedient at the time. It’ll probably work, somehow, in Cyprus. But it won’t work forever.

Andrew Ross Sorkin defends the Cyprus deal today, on the grounds that (a) Cyprus is “tiny”, and “largely irrelevant to the global economy”; (b) Cyprus is a genuinely unique case; (c) it would be grossly unfair not to bail in Russian depositors, who are generally losing less than they’ve made in interest over the past few years; and (d) the Greek alternative “will not work in Cyprus”, and that therefore (this last bit is only implied, never stated outright) the current plan is really the only option.

Notably, Sorkin doesn’t attempt to defend the most indefensible part of the plan — the confiscation of wealth from depositors with sovereign deposit guarantees. While hedge-fund bondholders will get paid their full $1.4 billion on June 3, the date of Cyprus’s next coupon payment, small depositors with just a few hundred or a few thousand euros in savings will lose money which the Cypriot government had promised them was safe. Why is the government’s promise to foreign hedge funds more important than its promise to its own citizens? Sorkin never attempts an answer to that one.

And even if Cyprus is tiny and irrelevant to Andrew Ross Sorkin, it most certainly isn’t tiny and irrelevant to the hundreds of thousands of people who live there, and deserve for their government to deliver the best possible plan it can.

Which raises the single biggest question facing the Cypriot parliament as it prepares to vote today: should it accept the deal on the table, or should it hold out for something better? And if it chooses the latter option — as seems likely — should it simply fiddle with the tax-rate percentages, much as one might fiddle with the Breakingviews Cyprus calculator, or should it try to build something which is more different and more fair? Most importantly, what alternatives does Cyprus’s parliament have?

This is where Sorkin’s column is (at least in its implication) wrong: there is an alternative. It is clearly better, in every regard, than the option currently on the table. And it most emphatically is workable. We know that it’s workable because it has been put forward by none other than Lee Buchheit, the godfather of sovereign debt restructuring, and for decades, in dozens of sovereign contexts, every time that Lee Buchheit has said something can be done, he’s been absolutely right.

Here’s the short, three-page paper: it’s called Walking Back from Cyprus, and it’s authored by Buchheit and his frequent collaborator, Mitu Gulati of Duke University. Their plan is simple:

First, leave all deposits under €100,000 untouched. Hitting those deposits was by far the biggest mistake of the Cyprus plan as originally envisaged, and everybody would be extremely happy if guaranteed depositors could be kept whole.

Second, term out everybody else by five years, or ten if they prefer.

That’s it! That’s the whole plan, and it’s kinda genius. If you have bank deposits of more than €100,000, they will be converted into bank CDs, with a maturity of either five years or 10 years — your choice. If you pick the longer maturity, then your CD will be secured by future Cypriot gas revenues, which could amount to hundreds of billions of dollars.

And if you have sovereign bonds, they too will be termed out by five years, giving Cyprus a bit of breathing room to get its act together.

Do that, say Buchheit and Gulati, and you manage to reduce the size of the needed bailout by more than the €5.8 billion that Cyprus is currently planning to raise with its tax on bank deposits — and you don’t touch anybody’s principal at all. To be sure, the new CDs, which would be tradable, would surely trade at less than par: there would be a present-value haircut on deposits over €100,000. But that’s going to happen anyway. And at least in this case patient depositors will have a chance of getting all their money back in full — with interest. And, most importantly, guaranteed depositors will remain unscathed.

This is the deal that no one had the imagination to put on the table during all-night negotiations last week, and it makes a lot more sense than what we’re looking at right now. In the first round of negotiations, the Germans had the upper hand, presenting Cyprus with a take-it-or-leave-it deal. Buchheit and Gulati have now given the Cypriot parliament the opportunity to turn the tables: pass a bill along these lines, and tell the Germans to take it or leave it.

The Buchheit/Gulati plan would cost Germany no more than the current plan, so the Germans would have no good reason to veto. But if the Germans did veto, then the result would be a sovereign nation being forced to exit the Eurozone: the worst possible outcome of all. Given that kind of ultimatum, I suspect the Germans would sign on to the Cypriot plan.

The ball is in the Cypriot parliament’s court today, and most observers are expecting the current plan to go through, with a tweak here or there to the tax rates and the points at which they kick in. But Buchheit and Gulati have now given Cyprus’s parliament a clear Plan B. If the lawmakers want to reject the Eurogroup’s plan, they know what they must do.

I stuck my neck out in January, saying that Cyprus was “certain” to default. After all, the Europeans weren’t willing to come up with the €17 billion needed to bail the country out, and EU economics commissioner Olli Rehn told the WSJ’s Stephen Fidler that Cyprus would have to restructure its debt. But now the bailout has arrived, and — in something of a shocker — there’s no default. Instead, €5.8 billion of the bailout is going to come directly from depositors in Cyprus’s banks, in the form of what the EU is calling an “upfront one-off stability levy”.

Don’t for a minute believe that this decision is part of some deeply-considered long-term strategy which was worked out in constructive consultations between the EU, the IMF, and the new Cypriot government. Instead, it’s a last-resort desperation move, born of an unholy combination of procrastination, blackmail, and sleep-deprived gamesmanship.

The details aren’t entirely clear yet: we’re told that deposits of more than €100,000 are going to have to pay a tax of 9.9%, for instance, but it’s not obvious whether that applies to all of the large deposit or just to the amount over €100,000. And there’s still a real chance that the Cypriot parliament could scupper the whole deal. But for the time being, everybody’s going on the assumption that the deal will go through, that Cyprus will get its €10 billion bailout from the EU, and that everybody with a Cypriot bank account in Cyprus (a group which includes members of the UK military) will see their accounts taxed by at least 6.75%.

In January, I said this wouldn’t happen:

The last thing that Cyprus or any other country needs is a bank run, which will leave the national balance sheet in the classic pinch where “on the left, nothing’s right, and on the right, nothing’s left”. What’s more, in many ways the precedent of forcing depositors to take a haircut would be even more damaging than the precedent of imposing a haircut on Greek bondholders: at that point there would be really no reason at all to have deposits in any Mediterranean country.

It might seem a little bit like shutting the stable door after the horse has bolted, but the lines in front of broken ATMs certainly suggest that there will indeed be a substantial bank run out of Cypriot banks when they reopen on Tuesday morning. (Cyprus’s loss, here, is likely to be Latvia’s gain.) Cyprus has been relying up until now on its status as an offshore financial center, especially for Russians. That has bloated its banks with deposits, and if the deposit bubble bursts, the government has no money at all to bail out the banks. Cyprus’s president, Nicos Anastasiades, said today that he was forced to choose this path because the only alternative was the collapse of Cyprus’s two major banks, with “catastrophic” consequences. What he didn’t say is that those banks aren’t remotely safe yet — not with the prospect of a massive bank run hanging over their heads.

And of course it’s not only Cyprus where a bank run is a very real fear. If bank deposits can be seized in Cyprus, they can be seized in other EU countries as well. Ed Conway has a fantastic post explaining exactly why this is a horrible idea:

Given that this policy was not merely rubber-stamped but engineered by Eurozone finance ministers and the IMF (indeed, the IMF wanted an even deeper cut of deposits), it sends a disquieting message to anyone with deposits in a euro area bank. Although the ministers were quick to insist that this is a one-off and is “exceptional”, anyone even vaguely acquainted with the initial Greek bail-outs will remember precisely how long such exceptions last.

“The best the rest of the world can hope for,” says Neil Irwin, “is that Cyprus’s case is sufficiently unique that it won’t spark panic in Athens and Madrid (or in Lisbon, Dublin and Rome).” But his post is headlined “Why today’s Cyprus bailout could be the start of the next financial crisis”, which gives a reasonably good idea of how optimistic he is that any bank run in Cyprus will be contained.

And Europe won’t be home dry even if depositors in Portugal do decide to keep their money in their home country on Monday morning. That might make this bailout look like a brilliant wheeze. But the consequences of this choice are permanent: countries like Ireland and Portugal might not be at risk of a deposit tax right now, but they’re still getting bailed out on a continuous basis, and the more fraught the bailout negotiations become, the more likely it is that the EU will insist on bailing in depositors. It’s an option on the table, now, and as a result a deposit run is surely more likely to happen whenever a Eurozone country finds itself in need of a bailout. Which, of course, is always the worst possible time for a bank run.

From a drily technocratic perspective, this move can be seen as simply being part of a standard Euro-austerity program: the EU wants tax hikes and spending cuts, and this is a kind of tax: “a one-off wealth tax”, as Matt Yglesias puts it. Other taxes would raise less money, or if they didn’t they would be more harmful to the Cypriot population, since much of this one is going to be paid by Russians. Cypriots are sadly going to have to pay somehow, and although this is an unpleasant way of forcing them to do that, it’s also extremely effective and almost impossible to replicate by any other means.

But there’s something sacred about bank deposits, and especially about insured bank deposits. The one part of this scheme that no one is defending is the 6.75% tax on deposits less than €100,000 — the level to which Cyprus guarantees all deposits. As Nick Malkoutzis puts it,

Anastasiades also has to explain to Cypriots why small-time depositors have to pay a similar levy to the one some eurozone countries supposedly demanded so alleged Russian oligarchs would be forced to pay for bailing out the island’s banking system. Furthermore, he has to inform them why the Cypriot government’s pledge to guarantee deposits up to 100,000 euros – supposedly even in the most extreme circumstances – is not even worth the paper it was written on.

What we’re seeing here is the Cypriot government being forced to break one of its most important promises — the promise that if you put your money in the bank, and your deposits total less than €100,000, then they will be safe. What’s more, there’s no good reason for insured deposits to be hit in this manner: the same amount of money could be raised just by taxing the uninsured deposits at a slightly higher rate. The insured depositors are being hit, it seems, just so that the uninsured depositors can be taxed at single-digit rather than at a double-digit rate.

Meanwhile, people who deserve to lose money here, won’t. If you lent money to Cyprus’s banks by buying their debt rather than by depositing money, you will suffer no losses at all. And if you lent money to the insolvent Cypriot government, then you too will be paid off at 100 cents on the euro.

This is more by accident than by design. As Joseph Cotterill explains, Europe dragged its feet on Cyprus for so long that it effectively missed the deadline for doing a bond restructuring. It takes time to put that kind of a deal together, and there simply isn’t enough time between now and Cyprus’s next big coupon payment to do that. As a result, the EU found itself with a massively reduced menu of options: either fund the bailout itself, in full — an option which the Germans were adamant would never happen — or force a haircut on Cyprus’s depositors. Given the balance of power in the Eurozone, it comes as no surprise that in this battle, Germany won and Cyprus lost.

They won dirty, too: by forcing a tough all-night negotiating session in which Anastasiades was given what you might call an offer he couldn’t refuse. Either confiscate deposits wholesale, or see those deposits rendered even more worthless when the ECB cuts off its funding to Cypriot banks, a decision which would — through devaluation and insolvency — lead to depositors losing as much as 60% of their money.

The big winner here is the ECB, which has extended a lot of credit to dubiously-solvent Cypriot banks and which is taking no losses at all. And although they might wake up bruised, the big Russian depositors are probably winners too, given that they risked losing everything and will end up losing just 10%. Finally, of course, there are all the hedge funds who have been betting that the Cypriot government won’t default: they’re all popping Champagne right now.

The big loser are working-class Cypriots, whose elected government has proved powerless in the face of decisions driven by Germany, and who are now edging towards fury. The Eurozone has always had a democratic deficit: monetary union was imposed by the elite on unthankful and unwilling citizens. Now the citizens are revolting: just look at Beppe Grillo. Across the continent, they’ve lost their democratic right to determine their own fate at the ballot box, and instead they’re being instructed what to do by Germans. Now, in Cyprus, they’re simply and directly losing their money.

Someone with €8,000 of life savings in the bank can ill afford to lose an arbitrary €540, but that’s exactly what is going to happen. The Cypriot parliament is probably not going to revolt this weekend, but any politician who votes for this bill is going to have a very, very hard time getting re-elected. This decision is important not only because of the precedent it sets with regard to bank depositors, but also because of the way in which it points up just how powerless all the Mediterranean countries (plus Ireland) have become. More than ever before, it’s Germany’s Europe. That’s bad for Cyprus — and it’s not even particularly good for Germany.

Many congratulations to Stephen Fidler, who has managed to get some actual news in Davos: EU economics commissioner Olli Rehn went on the record telling him that Cyprus is going to have to restructure its debt — just two weeks after ruling such a thing out.

That might come as little surprise, given that Cypriot banks were loaded up to the gills with Greek debt, and Greek debt suffered a 70% haircut. Cyprus is tiny, and could never afford the €17 billion needed to bail out the banks and the government — especially since that would bring the country’s debt load up to more than 140% of GDP.

Still, after the EU forced Greece to default, it drew a line in the sand: no more sovereign defaults, it said, since Greece was “unique and exceptional”. So this does go to show that you can’t really trust Europe’s promises. What’s more, Cyprus’s now-certain restructuring is going to be significantly messier than Greece’s was.

Greece’s debt restructuring was essentially unstoppable for one main reason: most of its debt was issued under domestic law, rather than foreign law. A tweak to domestic law, and suddenly the vast majority of Greece’s creditors were bailed in to any deal, whether they voted for it or not. Cyprus, in contrast, doesn’t have that luxury: its bonds are mostly issued under foreign law. And that means any restructuring is going to be much more difficult.

Lee Buchheit and Mitu Gulati have a potential solution to that problem, which involves amending the treaty governing the European Stability Mechanism. But the other big problem in Cyprus will still loom: the question of the country’s bank deposits.

In a country like Cyprus (or Iceland, or Switzerland), where the banking sector is many multiples of national GDP, there’s very little distinction between rescuing the banks and rescuing the country. And if the asset side of the banks’ balance sheet is full of Greek sovereign debt, the liability side is equally dodgy: Cyprus is a notorious center of dodgy offshore banking, especially for Russians. If Cyprus is going to restructure its liabilities, it’s going to have to face one huge question: will those restructured liabilities include Russian and other foreign deposits?

If there’s any hint that Cyprus might force foreign depositors to take some kind of haircut, of course, there will be a massive run for the exits, and Cyprus’s current solvency problem will become a much more serious and immediate liquidity problem. The last thing that Cyprus or any other country needs is a bank run, which will leave the national balance sheet in the classic pinch where “on the left, nothing’s right, and on the right, nothing’s left”. What’s more, in many ways the precedent of forcing depositors to take a haircut would be even more damaging than the precedent of imposing a haircut on Greek bondholders: at that point there would be really no reason at all to have deposits in any Mediterranean country.

That said, foreign deposits in Cyprus amount to some €30 billion: the opportunity cost of protecting them in full, while imposing a substantial haircut on Cyprus’s bonded creditors, would be huge.

So even if Europe has made its first big decision — to force Cyprus to default — it still faces many more. Should it amend the ESM treaty to make any restructuring easier? Should it impose a haircut on Cyprus’s uninsured depositors? And how can it structure the process to minimize the chances of a messy bank run, default, and possibly even exit from the euro? It’s easy to dismiss Cyprus as too small to worry about. But it’s still an important sovereign state. And if the EU missteps on Cyprus, that would bode very ill for any similar problems in bigger eurozone countries in the future.