EVEN by the standards of European policymaking, the past week has been a disaster. In the early hours of March 16th, nine months after Cyprus first requested a bail-out, euro-zone finance ministers, led by the Germans, offered a €10 billion ($13 billion) deal, well short of the €17 billion needed. Who ordered whom to do precisely what is not clear, but the Cypriots then said they would raise a further €5.8 billion by imposing a levy on depositors—of 9.9% on savings above the €100,000 insurance-guarantee limit, and 6.75% for deposits below it. Chaos ensued, not least among the many Russians (reputable or not) who have parked their money in the lightly regulated island. On March 19th, with crowds in the streets and all the banks firmly shut, the Cypriot parliament rejected the bail-out package (see article). As The Economist went to press, the scene had shifted to Moscow, where the Cypriots were trying to persuade Vladimir Putin and his cronies to contribute some money in exchange, perhaps, for future gas revenues.

Cyprus is a Mediterranean midget, with a GDP of only $23 billion. But this crisis could have poisonous long-term consequences. Eight months after the European Central Bank appeared to have restored stability by promising to do whatever it took to save the currency, the risk of a euro member being thrown out has returned. It has increased the chances of deposit runs (if Cyprus can grab your money, why not Italy or Spain?). And it has revealed the lack of progress towards a durable solution to the euro’s troubles. Ideally, all this will prompt the Europeans to push ahead with reforms, but with a German election in the autumn that seems unlikely.

Towards Cyprussia?
Cyprus is broke. Its debt, if it took on its banks’ liabilities, would hit 145% of GDP. This newspaper suggested recapitalising Cypriot banks, on a case-by-case basis, directly through the European Stability Mechanism (ESM), thus breaking the vicious circle where weak sovereigns bail out weak banks. We also argued for depositors and senior bondholders to be spared—not out of any particular love for rich Russians, but because of the fear of bank runs in larger weak euro economies. The Europeans instead decided to lend the money directly to the Cypriot government; and the Cypriots, perhaps bullied by some creditors, then decided to clobber all the banks’ depositors, even the insured ones.

This was ingeniously loopy. Cyprus is odd, because virtually all its banks’ liabilities are deposits (as opposed to longer-term bonds). Yet, of the 147 banking crises since 1970 tracked by the IMF, none inflicted losses on all depositors, irrespective of the amounts they held and the banks they were with. Now depositors in weak banks in weak countries have every reason to worry about sudden raids on their savings. Depositors in places like Italy have not panicked yet. But they will if the euro zone tries to “rescue” them too.

The blame for this should be shared between Cyprus and its creditors. Cyprus is guilty of a lot. It welcomed in the Russians and allowed its banks to get far too big: their assets reached 800% of GDP in 2011. The banks were in trouble even before the restructuring of Greek government bonds opened up a €4 billion hole in their accounts last year. As for the creditors, Angela Merkel’s priority seems to have been to appear stern before the German election, and the European Central Bank, whose job it is to protect financial stability, was party to a scheme that ended up jeopardising it.

What should Europe’s leaders do now? The worst outcome would be to allow the Cypriots to slide towards the exit. That would be disastrous for the island. And the euro zone would be wrong to imagine that Cyprus is tiny enough to let go safely. The currency’s credibility rests on the idea that it is irreversible.
Leaving it to the Russians to save Cyprus, by letting them recapitalise its banks and grab a slice of its gas, is an answer, but not the best one. However tricky the politics of using German taxpayers’ money to bail out Russian depositors, a deal that ends up entrenching Cyprus’s status as an offshore Russian satrapy would be a perverse outcome. A revised deal with the euro zone would be better.

The yoke of union

This newspaper would still prefer to recapitalise Cyprus’s banks directly through the ESM. That option is plainly not on the table. The best that can probably be done now is to spare the insured depositors, bail in other bank creditors and, given the economic damage caused in the past week, increase the amount of the bail-out. The financial assumptions in the rejected deal are already out of date. There will be capital flight when the shuttered banks eventually open; the island’s offshore-finance business plan is now bust. It needs to find new sources of prosperity, including faster exploitation of its recent Mediterranean gas finds—although these can be overplayed (see article). The best long-term plan for its economy would be a deal with the Turkish-Cypriots to reunify the island, which would boost tourism and GDP.

More broadly, Cyprus’s tragicomedy should prompt Europe’s leaders to get a move on. Even if only uninsured deposits are hit, a line has been crossed. A formal European bail-in regime is needed as soon as possible, one that requires banks to hold a layer of loss-absorbing senior debt designed to spare depositors, both insured and uninsured, in all but the last resort. That promises a more predictable environment, but it will also entrench fragmentation, with borrowers in weak countries finding it harder and more expensive to gain access to credit. The only solution to such fragmentation is a proper banking union and limited mutualisation of sovereign debt.

The political consequences are toxic. Cyprus is the latest peripheral country to feel mistreated by creditor countries. For their part creditors resent the fact that their financial support is summarily discounted. The euro-zone economy is stagnant. Protest parties are gaining popularity. The euro was supposed to be the manifestation of a grand political project. It feels more like a loveless marriage, in which the cost of breaking up is the only thing keeping the partners together.