It doesn’t create a lot of confidence in Europe that tiny little Cyprus, with a GDP less than Vermont, is now causing immense turmoil.
Though to be more accurate, events in Cyprus aren’t causing turmoil as much as they’re causing people to examine both government finances and bank soundness in other nations. And that’s causing anxiety because folks have taken their heads out of the sand and looked at the reality of poor balance sheets.
Looking closer at the specific mess in Cyprus, an insolvent financial sector is the cause of the current crisis, though the problem is exacerbated by the fact that the government has dramatically increased the burden of government spending in recent years and therefore isn’t in a position to finance a bailout.
But that then raises the question of why Cyprus is bailing out its banks? Why not just let the banks fail?
Well, here’s where things get messy, particularly since we don’t have a lot of details. There are basically three options for dealing with financial sector insolvency.
As far as I can determine, Cyprus wants to pick the third option, sort of akin to the corrupt TARP regime in the United States. But that approach can only work if the government has the ability to come up with the cash when banks go under.