Could a full-blown European financial crisis begin in tiny Cyprus, with a population of just more than 1 million and a gross domestic product of only $23.6 billion? The idea is only slightly stranger than the notion that this Mediterranean offshore-banking center, partially occupied by Turkey since 1974, belonged in a currency union with Germany in the first place. But Europe's leaders, in their wisdom, let Cyprus join the euro zone in 2008, and now the future of a continent hinges on bailing out the island and its insolvent banks.
European policymakers, led by Chancellor Angela Merkel's German government, have made a hash of things so far. Cyprus needs to recapitalize its financial system, which is badly damaged by exposure to the sovereign debt of neighboring Greece. The International Monetary Fund and E.U. governments agreed to lend $13 billion of the necessary funds, in return for the usual austerity and a contribution of $7.5 billion from the Cypriot government.
The only way Cyprus could get its hands on that much cash, however, was to "tax" the $88.4 billion on deposit in its banks. Though basically a polite confiscation, it was defensible under Cyprus' special circumstances, which include the fact that there was relatively little money to be had by soaking the banks' bondholders. Forty percent of the deposits belong to foreigners, wealthy Russians especially, who are relatively well-positioned to share in their tax haven's risks; a bailout that didn't hit the Russians would have been politically impossible in Germany.
For the Cypriot government, however, taxing fat cats risked alienating Russian Prime Minister Vladimir Putin, whose government Cyprus already owes $3.3 billion for a previous bailout. So President Nicos Anastasiades — with the inexplicable acquiescence of Berlin — tried to shift some of the burden onto small accounts, those with less than 100,000 euros, which is the upper limit for deposit insurance. Cyprus' parliament rejected the plan in the face of an entirely foreseeable middle-class uprising. And it's a good thing, too — violating the deposit guarantee for Cypriot savers would have set a dangerous precedent, possibly destabilizing banks across Europe.
That bad idea may be dead, for now, though the mere fact that it was proposed could haunt savers in Italy, Spain and Greece. Meanwhile, only other difficult options remain: Cyprus could ask Mr. Putin for more aid, in return, perhaps, for a stake in its offshore natural gas deposits; the island could default and, probably, exit the euro zone; or it could yet cobble together a deal with the IMF and the Germans under which it limited the deposit "tax" to large, uninsured deposits.
The third seems like the least bad option, but given the nationalist backlash in Cyprus against Germany over the original scheme, it's anyone's guess what Cyprus will do; at last check, its finance and energy ministers were visiting Moscow.
How ironic if the end result of euro-zone overstretch into Cyprus turned out to be an expansion of Russian influence over European Union turf. Apparently the creators of the euro zone underestimated geopolitical risk — along with the difficulties of establishing a common currency among self-interested nations that had no true central bank, joint bank regulation or common fiscal policy. After three years of crisis, those design flaws remain largely uncorrected. The Cyprus mess, though still unlikely to trigger a European collapse, is a warning that the time remaining to repair those flaws is not unlimited.