Why Europe’s Response to the Cyprus Crisis Has Been Ineffectual

It's stymied by events that took place decades ago—including World War II and the rise of Hitler.

03.24.13 8:45 AM ET

Once again, a tiny economy in Europe, Cyprus, is threatening to unravel the global financial system. If you want to understand what is going on, read the Financial Times, or watch CNBC, or get Neil Irwin’s soon to be published The Alchemists: Three Central Bankers and a World on Fire. Any one of these will help shed light on the fundamental weaknesses of the European arrangement, in which many countries share a monetary policy and currency but have pursued wildly divergent fiscal and bank-regulation policies.

An employee of Cyprus Laiki (Popular) Bank reacts as he takes part in a protest outside the parliament in Nicosia on March 22, 2013.  Cyprus is locked in "hard negotiations" with a troika of lenders to save the eurozone member's banking system and economy in general from ruin, government spokesman Christos Stylianides said.

Patrick Baz/AFP/Getty

An employee of Cyprus Laiki (Popular) Bank reacts as he takes part in a protest outside the Parliament in Nicosia on March 22, 2013.

But if you want to understand why the European response to the crisis has been so ineffectual and halting, you have to look to history. In Cyprus, as was the case with Greece and Ireland, we are seeing historic pathologies influence current policy.

It starts with Germany, which dominates European monetary and financial policymaking. In effect, Germany, as the largest and most powerful nation in the euro zone, exercises veto power over the crisis response efforts. As it does so, however, it is impaired and heavily influenced by its own horrific failings of nearly a century ago.

The European Central Bank was very slow to run an expansionary monetary policy in large part because Germany and other nations feared it would ignite inflation. Policymakers and investors around the world today still vastly underrate Germany’s paranoia when it comes to rapidly rising prices. When Americans think of inflation, they think of Jimmy Carter, the 1970s, and gas lines. Bad times, but ones we quickly put behind us. To Germans, however, inflation touches off nerves from the hyperinflation of the 1920s and ’30s, which brought about the destruction of the Weimar Republic, the loss of savings, and, ultimately, the rise of Adolf Hitler.

People queue to withdraw their savings at a Cypus Popular Bank (Laiki Bank) ATM in Athens on March 22, 2013.  The chief of ailing Cyprus Popular Bank, the island's second largest, slammed the government's "Plan B" today to win an EU bailout, saying an earlier plan to tax deposits would have been preferable.

Louisa Gouliamaki/AFP/Getty

People line up to withdraw their savings at a Cyprus Popular Bank ATM in Athens on March 22, 2013.

Germany’s uncomfortable relationship to its own past is also influencing Cyprus’s efforts to dig out from its banking problems. Last week, the European Central Bank basically told Cyprus it could get a bailout only if it agreed to tax bank deposits. That was a nonstarter in Cyprus. And so its leaders started working on a counterproposal, which involved nationalizing the pensions of state-owned companies and using those funds. But as Liz Alderman reported in The New York Times, Germany wouldn't go for this. ”The suggestion of tapping pension funds touches off a visceral response in Germany, where history has proved the dangers of such ideas. German pensions were tapped to finance both world wars, and the idea remains anathema to German leaders today.” (Italics mine.)

There’s more history at work in the Cyprus crisis. German-Russian enmity has been a powerful driving force for centuries. So, too, has Russia's desire to integrate into Europe on its own terms. Since the fall of the Iron Curtain, Russia and Europe have warily drawn closer together—natural-gas pipelines bind Russia to Germany and Poland, Western companies view Russia as an emerging market, and free-spending Russians have established themselves in the South of France and London.

What does this have to do with Cyprus? Since 2008, when Cyprus joined the euro zone, Russian big shots have been using the country as a back door into Europe. They’ve used Cyprus banks to turn rubles into euros and then funnel the cash back into Russia. As The New York Times notes, “Cypriot entities, often owned by rich Russians, lent $40 billion a year to Russia from 2007 through 2011.” In 2010, Dmytry Rybolovlev, a Russian oligarch known for expensive real estate purchases, bought about 10 percent of the Bank of Cyprus, which is now in trouble. To a large degree, Germans and other Europeans regard a bailout of Cyprus’s banking system as a bailout of Russians with shadowy wealth. That, too, is unpalatable to Germans and most other Europeans. The Cold War may be over, but Europeans have long memories.

There’s one more interesting historical dynamic at work. The U.K. has steadfastly stayed out of Europe’s common currency regime, and as a result it has approached the bailouts of Greece and Ireland largely as an interested observer. But the U.K. has a more direct interest in this particular component of the European crisis. Until 1960 Cyprus was part of the once-mighty British Empire. Today, it is home to two British military bases, which are still sovereign U.K. territory. And aside from a few thousand military personnel, tens of thousands of British expats live in Cyprus, lured by the same forces that draw Northeasterners to Florida—retirement communities, low taxes, and sunshine. Which is why the U.K. last week dispatched a military aircraft full of euros to the island.

In the heart of ancient Europe, the past isn’t past. In many ways, it’s the present and the future.