Tyndall Monthly Commentary: Does Cyprus Really Matter?

As has no doubt been stated many times by many commentators, Cyprus is a small country with a pleasant climate in the East of the Mediterranean Sea that has a GDP that is, according to CNBC at least, probably only the equivalent of Boise, Idaho.  With no offence intended to the residents of Boise, the fact that this small economy has run into difficulties would not at first sight seem to be of particular significance to the outlook for the global economy.  Where Cyprus does matter, though, is that it is part of the Euro system and, were it to leave, it could cause systemic failures in the European and perhaps even global financial system, particularly if counterparty fears rose again (as they did in the wake of the Lehman crisis).  Fortunately, we do not suspect that the Cypriot economy or its banking system will be allowed to collapse; if the EU does not come to its aid (and hopefully it will do so without seizing deposits from Cypriot residents) then it is quite likely that Russia will rescue the country but this does not mean that investors should ignore what is going on in this small economy.  In fact, we believe that what is happening tells us much about what is happening within Euro policymaking circles.

It seems incredible even to us that it was only seven weeks ago that we visited Frankfurt and were told by a senior staffer at the ECB that the central bank needed to tighten its stance “soon” because the Euro region was facing the threat of higher inflation in 2015, or perhaps even earlier.  The analysis that he used to justify this seemingly strange assertion appeared to be based on what could only be described as a 1980s-era Bundesbank “manual” that postulated that somehow there was still too much money within the Euro region relative to the long-term demand for money (that is, that there were “excess money balances” as a result of the system’s overexpansion during the mid-2000s) and that this situation might one day trigger inflation in the Euro region.  We may have stated that this approach and its theoretical underpinning were based on some unrealistic assumptions about the likely stability of the demand for money within the Eurozone but, nevertheless, even under quite intense scrutiny, the ECB official “stuck to his guns” about the need to tighten and within a matter of weeks the markets were indeed beginning to discount the likelihood of an ECB tightening, despite the still-appalling economic weakness that the current data was – and still is – revealing in the region.  Consequently, at the time, we wondered whether the ECB, in reality, had some other agenda.
In fact, the analysis offered by the ECB seemed, at first sight, to be so strange to us that we were quite shocked by the views expressed (particularly given the large negative output gaps that much of the Eurozone are experiencing at present), but, with hindsight, we wonder whether what we were offered was, in fact, a glimpse of the divide that is opening up within the ECB itself and which seems to be “swallowing” Cyprus.