What Does Cyprus Mean for Us?

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The recent events in Cyprus have many in our country debating whether Cyprus and the larger financial problems mean anything for the U.S.  There are two questions that people ask most: 

1.  Will the events in Cyprus affect us?

2.  Can we become like Cyprus if our debt becomes too large?

First, it is important to quickly cover some background on Cyprus and the larger problems in several European countries like Portugal, Italy, Ireland, Greece and Spain (PIIGS).  The bottom line is that all of these countries face growing turmoil due to large debt compared to their GDP.  Their ability to pay back their debt is in serious doubt so other countries are unwilling to loan them more money unless they take steps to curtail their deficits through a combination of spending cuts and tax increases, typically referred to as austerity measures.  For more background on austerity, I refer back to an older post on the topic:  The Myths of Austerity.  The biggest difference between a country like Cyprus and the U.S., and this is important, is that Cyprus does not have a sovereign currency.  They belong to the Eurozone and use the Euro as their currency.  That means they cannot simply print more money to pay off their debt.  Cyprus made headlines recently because of the seizure of portions of private bank accounts to help pay off their debt.

So to answer the first question, can Cyprus affect the U.S, the answer is no in the short term but possibly in the long term.  Cyprus is a tiny country so their economic problems should not directly affect the U.S.  However, the problems in Cyprus and the reaction to the problem of seizing people’s private funds could cause more widespread concern in the PIIGS countries.  If people in those countries believe that their bank accounts could be targeted as well, they could cause a run on the banks and create greater economic problems throughout Europe.  The other short term problem that could happen is if countries throughout Europe decide that the Euro is no longer a viable currency and a nation like Germany, tired of being forced to bail out their Mediterranean neighbors, decides to dissolve the Euro experiment.  Although some feel this is a better option in the long term, the short term chaos would cause problems here in the U.S. since Europe is our largest trading partner.

Now for the second question, can something like Cyprus happen here, the short answer is no but the larger answer is a little less definite.  Remember when I said that we have a sovereign currency.  So technically we can always pay off debt by printing more money.  The problem becomes when we accumulate too much debt and print too much money.  Experts disagree on when that point occurs, but if more currency is put into circulation, eventually the value of all of the currency decreases.  That is inflation.  Now creditors will want more return for their investment because each dollar they receive back is worth less, so the price of borrowing goes up.  Now some argue that despite all the money that the Fed has printed over the last few years that inflation is still low.  They miss the point in two areas.  One, the official inflation rate or Consumer Price Index (CPI) is low because it includes housing rental prices, which have been low due to the crash of the housing market.  With a lot of empty houses due to foreclosure and people underwater and unable to sell their homes, rental prices dropped.  But, think about the things you buy every day like gas and food and you get a sense of real inflation.  Also, higher unemployment rates have kept inflation low because fewer people have money to spend.  However, no one can argue that an almost limitless printing of money will eventually cause inflation.  Without a gold standard to back up our money, the currency gets its value from the full faith and credit of the government.  In other words, creditors have to believe the money has value.  If there is so much of it in circulation, the dollar will lose value, making everything we buy more expensive.

So Cyprus and the events in other European countries are important to watch for a couple of reasons.  One, a larger economic catastrophe in Europe will affect our economy.  Two, the problems countries like Cyprus and Greece have with their debt is actually a better comparison to the issues our states and cities will face due to debt or bankruptcy.  The national debt of Cyprus is about $19 billion.  The debt of California is about 20 times that and like Cyprus, California does not have a sovereign currency.

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