Last month I argued that optimism in financial markets must be balanced against the risk of pessimism on growth from a fiscal squeeze in the US and the return of the euro debt crisis. The jury is still out on the first risk but the second risk has come back with a vengeance. The debacle of the bailout deal negotiations over Cyprus revealed yet again that the continued recession in Europe is putting the single-currency area under pressure. Contagion from Cyprus to Italy and Spain has been avoided, partly because Cyprus is a small player in the eurozone, partly because the taxpayer (both local and eurozone) has taken less of the burden of any bailout with the bail-in of Cypriot bank depositors. And it’s partly because Mario Draghi and the European Central Bank have continued to talk about being ready to support the sovereign debt of distressed eurozone states.
But bailing in depositors has raised the risk of deposit flight every time there is a whisper of a crisis anywhere in the eurozone. And the introduction of capital controls threatens the principle of the single currency, the longer they last. Furthermore, the package is probably way too small to cover the funding needs of Cyprus over the next three years.