Cypriot crisis: Will Germany's tough stance backfire?

A Cypriot employee of the Laiki Bank holding a placard saying 'Merkel Caput'

I am blogging instead of broadcasting today as I have laryngitis. But I might still get shouty. The question people in financial markets are shouting about is: what on earth does Germany think it is doing? It triggered the Cyprus crisis and is playing hardball, rejecting the Cyprus government's latest attempt to solve it. Here is my take on what is happening.

First the facts.

Last Friday in Brussels the Germans led Eurogroup ambush of the new president of Cyprus, demanding an immediate resolution to the country's debt crisis.

They were the ones to demand depositors take losses, although at first Mrs Merkel assured them the ordinary savers would lose just 3% of their money. Then, according to a report in the Financial Times, Wolfgang Schauble, the German finance minister, upped this to 6% and 10% for those with savings above 100,000 euros - though this version of events is disputed by German CDU MP Dr Michael Fuchs, who told Newsnight on Monday it is "not our problem" how Cyprus raised the money - as long as it is raised.

This immediately nullified the explicit 100,000 deposit guarantee in the eurozone and the president of Cyprus said it would never pass through parliament.

So to focus Cypriot minds, Jorg Assmussen, the German socialist who heads the council of the European Central Bank also told them the ECB was pulling emergency funding to Laiki Bank, thus rendering it insolvent.

Moral hazard

Now, after a week of Cypriot attempts to get Russia to soften the size of the bailout, which Germany also nixed, the Germans have rejected the latest plan out of Nicosia, which would involve nationalising the country's pension schemes and also mortgaging future revenues from an oil and gas field that comes on stream in 2020.

Germany's intent in all this is, at a textual level, clear: they want to avoid creating a moral hazard, rewarding a country that has sold itself as a rule-free playground for Russians who want to keep their money offshore.

They want to insist any money lent from the European Stability Mechanism (ESM) bailout fund can be paid back on a sustainable basis, and so they need a debt write off.

In Greece this came from banks who had bought government debt; but in Cyprus few global banks were stupid enough to buy this debt, and so the money has to come from Cypriots themselves.

But there is a wider, strategic and philosophical basis to Germany's stance. First, they are engaged in a tough negotiation over the shape of a future banking union in Europe.

Decisions taken in Germany are directly affecting ordinary Cypriots

Once that union is in place, say Germany, Finland and the Netherlands, direct centralised bailouts of banks will be allowed: there will be effective pooling of taxpayer money within the eurozone. But…

This north European trio are insisting the new banking union cannot cover "legacy debts": that is, from the pre-2007 crisis.

So it is logical to pursue at the same time a banking union with fiscal transfers in future, and a cleanup of the old debts with the countries responsible taking the pain.

On top of that the German public is increasingly outraged over the scale of its taxpayer exposure to what it sees as profligate peripheral countries.

So that is the principle, the strategy and the tactics of Germany.

But here is the problem: the outcome of their actions is repeatedly creating situations they do not want.

Cyprus, like Greece and Spain beforehand, creates an existential crisis for the euro. Once one country leaves, however small, the fiction that it is a permanent currency union is exposed.

In the process of imposing perfectly rational economic pain, something else is revealed.

The eurozone does not involve shared sovereignty - which is hard enough for some countries to accept under austerity pressures. In fact it has come to involve the sovereignty of the solvent nations over the insolvent nations.

Contagion

What shocked everyone, not just Cypriots, was the sudden, tactical and coercive manner in which both the IMF and the ECB attacked the incoming Cyprus government.

It was the equivalent of the cops breaking down your door at 6am: perfectly legitimate if you have the legal right to do so, but it can seem excessive.

So Germany is left with a mismatch between intent and outcome. And the outcome could get really nasty. It is not just the contagion effect on southern Europe of seeing queues at cash machines and people going bust. Or the potential "me too" effect on Greece if Cyprus leaves.

What is being presented is a choice: stay in Europe or become part of the Brics, beholden to Russia for finance, Israel for various as yet untransparent deals, remain continually at odds with Turkey and Northern Cyprus, and once your finances have recovered, sell yourself as a kind of posh nightclub to the world.

Actually, the polls are telling us, and my colleagues on the ground report, more and more Greek Cypriots are seeing this as a viable option. Given the choice between a busted euro and a vibrant, if rule-free, future in the Russian penumbra, they may choose the latter.

Israel and Iran

This FT article gives a flavour of the diplomatic and military unknowns out of a closer Russian-Cypriot relationship.

The Russian Navy could gain a Mediterranean base, but Russian intelligence would then lose the ability to mingle freely with Nato personnel, suggests the author, so it is swings and roundabouts.

I would suggest the island is currently also something of a diplomatic and intelligence battleground for Israel and Iran, so it gets even murkier.

In the end the crisis has exposed two weaknesses of modern German politics: first on economics, they don't seem able to move away from principle-driven action to outcome-driven action.

On the bigger geo-diplomacy - driving an EU member state into the arms of the Russians and sending a big sub-textual signal to other states close to Russia - it just begins to look like the Germans cannot do geo-politics.