One way or another, the situation is Cyprus likely marks a major turning point in the eurozone crisis. It could be the beginning of true disaster for the zone, eventually leading to a series of sovereign debt defaults and possible exits from the euro area. It could also be the point at which we learn that the eurozone has done enough to shore itself up and regain market confidence, so that a disaster in Cyprus does not spread, now or later, to other vulnerable countries. Yet, of course, the result could also be anticlimactic and not a turning point after all. Europe retains the ability to miraculously muddle through, neither truly fixing the Cyprus problem nor allowing it to turn catastrophic, living to fight another day.
It is extraordinarily hard to predict what happens next in Cyprus and the eurozone, which is why it is so puzzling that markets are not more scared. They appear to have crisis fatigue, producing a complacency that combines a tinge of cynicism about the long-term resolution of anything with a belief that the zone can keep dancing between the bullets, in the short run anyway.
There is the possibility that Russia, which has many interests in Cyprus, will provide the necessary financial aid, in lieu of the eurozone. However, Russia is far too canny for this to be a likely result, unless the maneuvering of elites behind the scenes at the Kremlin happens to align exactly as needed by the Cypriots. Overall, adopting Cyprus from its unhappy eurozone parents could be a very expensive folly. More likely, Putin strings the Cypriots along without making a binding offer of the necessary support.
There is a higher probability that the eurozone finds a politically acceptable way to increase its support and to bridge the gap with the Cypriots. However, the two sides just spent the last nine months trying to do this and were stopped by insuperable political and policy obstacles. These appear to have gotten worse, if anything, although one never knows how a crisis atmosphere may change the politics.
For their part, the Cypriots may flinch from what could become a total break with the eurozone, and possibly eventually the European Union as a whole. They might find a way to offer the required tax increases and expense cuts, possibly combined with a more modest tax on bank deposits that only hits the depositors with accounts above the insurance limit. However, political developments of the last few days show how hard this could be.
All of the other solutions are ones that risk spreading financial contagion to the weaker nations in the eurozone, either now or as a result of a future scare, such as further problems in Italian politics. Cyprus could choose to recapitalize its banks with government money, possibly with some depositor losses. This could lead very quickly to an inability for the government to fund itself, as the markets are unlikely to view its higher debt level as sustainable, which could in turn lead to the eurozone’s second sovereign debt default, after Greece. Cyprus might also feel the need to stop using the euro, in order to regain the ability to depreciate its currency and control its own interest rates. One trigger for this could be the inability to obtain outside funding and an unwillingness to raise taxes or cut expenses enough to eliminate its fiscal deficit and fund itself internally. Printing its own currency would allow it to pay its bills in the short run while it went through a larger adjustment process.
A default and/or exit from the euro would be a drastic step and one that could harm Cyprus very badly. More importantly for the rest of the world, it would raise risks of scaring depositors and government debt holders in the weaker parts of the eurozone, badly damaging those economies and raising the risk of a domino effect. This might not happen immediately, but could be a delayed reaction, raising the risks from any future scares.
However, the eurozone has made enough progress that there is a chance that markets and citizens elsewhere in the eurozone would view the Cypriot situation as unique and not something which effects their own decisions. If that were to prove to be the case, it would be a very positive signal, although it would also carry its own risks. For example, Germany and other fiscally strong eurozone countries might be tempted to harden their line with Greece, Spain, and Italy, in the belief that contagion risks are lower than they really are. With some bad luck, this could eventually lead to a default or exit by a nation other than Cyprus, which would be more likely to have wider repurcussions.
Personally, I’m scared. There is a significant chance that Europe muddles through once more and a small chance that the crisis vindicates those who argue the zone has strengthened itself enough to handle a problem like this. But, I also see a substantial probability of disaster, either immediate or with a delayed fuse.