The architects of the euro had one primary strategic goal. It was, to play on Lord Ismay's famous quip about NATO, to keep the Americans out, the Germans in and the Mediterranean states down -- at least as far as monetary policy was concerned. The Cypriot bailout package, which Dutch Finance Minister and Euro Group chief Jeroen Dijsselbloem said should be a model for future rescue packages, certainly holds true to this dictum.
Cyprus will now have to find a new trade. With its banking sector halved, the country faces a difficult if not impossible challenge to re-establish its status as a financial oasis. The high-risk political economy that fueled the tiny island-nation since 1974 has ended. Iceland, facing a similar calamity in 2008, re-discovered fishing.
The deal with the European Union and the International Monetary Fund that emerged on Monday grants Cyprus a €10 billion ($13 billion) loan that will not be used for bank re-capitalizations. In return, Cyprus will wind down the state-owned Laiki Bank and shift its salvageable components (along with €9 billion of European Central Bank debt) to the Bank of Cyprus. Laiki's uninsured depositors and bondholders will be wiped out. Bank of Cyprus depositors will also be heavily hit, allowing the country's debt-to-GDP ratio to remain at a sustainable level that can be brought down to 100 percent by 2020, according to the IMF.
The story behind the deal played out for months in Berlin. The Cypriot government originally lodged its request for an aid package in June 2012. While then-Cypriot President Demetris Christofias delayed negotiating formal terms for an assistance package, German parliament -- primed by four previous debates on bailout packages involving the European Stability Mechanism (ESM) -- had fierce discussions on the issue.
'Cesspool of Profligacy'
Germans have long had a deep-seated antipathy to tax havens and have sought to correct the arbitrage in the financial system that gives rise to them. This intolerance has been a mainstay of the German approach to global governance for the last five years. Berlin's 2008 pursuit, via the purchase of stolen data, of uncollected taxes on accounts held at LGT Bank by some 600 prominent "Davos men", including former Deutsche Post CEO Klaus Zumwinkel, led to a diplomatic incident between Germany and Liechtenstein. In 2010 the German government pursued tax evaders in Switzerland with a similarly shadowy data acquisition. Germany joined France in 2009 to push for G-20 sanction mechanisms, and Berlin has used domestic laws to compel tax havens to adhere to rules set out by the OECD in its codex of uncooperative offshore banking centers.
For the Germans, the Cypriot saga played into political tropes about moral hazard and free-riding tax havens. One German public intellectual described Cyprus in the Financial Times as a "cesspool of profligacy and haven for tax-dodging Russian oligarchs." German media are providing detailed analyses of other tax havens to which their countrymen might be exposed. The daily Die Welt declared recently that the tax haven as an economic model has been "exhausted." Luxembourg, with a financial sector more than five times the size of its €44 billion GDP has come under particular scrutiny. With a financial sector twice the size of its GDP, the United Kingdon could also become a point of interest.
How did the inclusion of wealthy foreign depositors in the Cypriot bailout become such an issue for Germany? Politics and polls. Despite its international critics, the euro-zone crisis management of Chancellor Angela Merkel's government has been virtually unassailable at home. The chancellor's personal approval rating is 68 percent and that of her government, just six months before national elections, hinges on her measured approach to the currency crisis. Given the general Teutonic hostility to tax havens and indignation about using taxpayer money to aid Russian oligarchs, it was clear that Berlin would insist on putting some proportion of uninsured deposits towards Cypriot debt repayment.
A Back-Door Transfer Union?
What is remarkable -- as the political forensics of the original March 16 bailout deal have become clear -- is that the Germans and others gave Nicosia great leeway to set additional terms of that initial bailout plan. The Cypriot government then broke precedent to include small deposits in the "bail-in" scheme, only to have parliament reject the move. The government's second major decision -- to protect Russian depositors at the expense of its own citizenry -- was also woefully impolitic, not just in Cyprus but also in Germany. Commentators have compared the idea of imposing losses on insured depositors to the October 2010 Deauville Declaration, which broached the possibility of haircuts on sovereign debt. The latter set up the eventual participation of sovereign-bond holders in Greece's debt restructuring.
In the end, insured deposits in Cyprus remained off limits. But German conditionality on the hit to uninsured depositors was left intact and even made more onerous.
Still, more precedents may be broken, such as the establishment of capital controls, which Cyprus is now mulling. Any such controls could be a direct violation of the treaties that form the basis of the EU's "free movement of capital," one of the theoretically sacrosanct "four freedoms of the single market."
Perhaps even more worryingly, the Cypriot crisis has put the credibility of the EU's banking-union project in doubt as deposit insurance -- long seen as the project's most difficult aspect -- becomes more urgent. Even the notion of direct bank recapitalization through the European Stability Mechanism, enshrined amid great fanfare in last summer's EU summit, seems to be in question.
Both of these policies continue to sit uncomfortably with the Germans, who see them as a back-door transfer union. Given the upcoming German elections, the Merkel government is unwilling to confront these truths, even if it acknowledged them at the EU summit in July 2012. German politics remains the central democratic process in euro-zone crisis management. The final March 25 bailout deal, after all, will not be voted on by the Cypriot parliament. But it will be voted on by lawmakers in Berlin.