The tiny island nation dominating headlines this week doesn't pose an immediate danger to the United States economy. But the situation in Cyprus underscores that amid the euphoria of record highs for the Dow Jones industrial average and signs of improvement in the housing and job markets, a dark cloud still looms over the U.S. recovery in the form of the eurozone crisis.
“It is an unfriendly reminder that the problems in Europe aren’t resolved,” said Ryan Sweet, a senior economist at Moody’s Analytics.
Cyprus is a small country in the Mediterranean Sea with a population of just over 1 million and an outsized banking sector, more than eight times as large as its gross domestic product. It’s in the news because this weekend, European officials announced a new 10 billion-euro bailout program for the economically struggling nation.
That doesn’t sound remarkable (we’ve seen bailouts in Ireland, Portugal, and Greece, after all), but the bailout program has a new feature: A levy would be imposed on depositors in Cypriot banks. Although it's been billed as a tax, the levy is understood as a broken promise. It's as if you put $100 into a savings account in your local bank and were told afterwards that you'd only be getting $80 back. If many people believe this will be the case, they'll pull their money out of the bank en masse, causing a run. Deposit insurance exists in the U.S. and elsewhere to ensure that doesn't happen, even if the economy takes a turn for the worst.
“The problem here is that the policy that’s been adopted essentially makes the deposit guarantee, which small investors thought they had, meaningless,” said Nigel Gault, chief U.S. economist at IHS Global Insight. The bailout proposal has sparked protests in Cyprus and fear of a run on the banks. According to the Associated Press, Cypriot banks are set to remain closed until Thursday to avoid such a situation.
U.S. economists say the risks to the United States are small at this point, as the country has little direct exposure to Cyprus. The fear is that the program would establish a precedent for other struggling European countries, like Portugal, Italy, and Spain. Next time they find themselves in trouble, memories of the Cypriot levy could cause a run on the banks in those larger economies, where the United States has greater exposure and that could cause a large-scale disruption in global credit markets.
“That’s a very dangerous message to send to people across southern Europe,” IHS's Gault said. Such a disruption could cause a selloff in U.S. equities and put a damper on business confidence. A dramatic drop in stock prices or a big drop in business sentiment could hurt the U.S. economic recovery.
The good news is that many steps stand between the situation today and that becoming reality: “What's happening in Cyprus, what would have to happen in Europe, what would then happen to financial markets, which would then happen to the U.S. markets and that's why I say we are many, I think, steps removed from that,” said Stuart Hoffman, chief economist at the PNC Financial Services Group.
U.S. stocks fell on Monday, breaking a steady upward climb that had brought the Dow to record highs earlier this month. But economists are shrugging off the slide in stock prices at this point. “To me, the market was looking for an excuse to go down a little bit and so Cyprus may be the excuse, but because it’s an excuse and not a fundamental negative for the U.S. economy, this will be a contained correction,” Hoffman said.
And the U.S. economy is better equipped to withstand a shock from abroad than it was earlier in its recovery, although it’s slightly weaker as a result of the across-the-board spending cuts known as the sequester that went into effect on March 1 and could take 0.6 percentage points off growth this year, according to the nonpartisan Congressional Budget Office. On Monday, the American Bankers Association released a statement emphaszing that the Cyprus situation “has no implication for depositors in U.S. institutions.”
The Cypriot parliament still needs to pass the bailout program and has delayed a vote on it until Tuesday. It may be able to soften the blow by introducing a more graduated tax or exempting smaller accounts. Still, this week's flare-up is a reminder for policymakers to keep their eyes on developments abroad as they weigh the economic year ahead.