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Morici: The Insanity of the Cyprus Crisis

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NEW YORK ( TheStreet) -- Cyprus did not manufacture its banking crisis. The European Central Bank and European Union bear that responsibility. Yet, Cypriots will pay the price for their dysfunctions.

Until recently, Cyprus was a prosperous island economy with robust tourism, shipping and a significant international banking sector. Its big banks, like others in Europe, attracted large overseas deposits and invested heavily in sovereign debt. In Cyprus, much of the money came from Russia and was invested in Greek bonds.

Like the United States, the large banks are subject to stress tests but with an important distinction. The Federal Reserve is responsible both for undertaking those tests and sustaining the operation and protecting depositors of large money center banks in a crisis. During the recent financial meltdown, the Federal Reserve printed billions of dollars to purchase souring bonds and the U.S. Treasury borrowed to inject new capital into large banks when their mortgage-backed securities failed.

In the eurozone, the European Banking Authority undertakes those stress tests, and in 2010 and 2011 -- well aware of their considerable holdings in Greek bonds -- determined Cypriot banks had plenty of capital to withstand a financial crisis.

Meanwhile, Greece was in the throes of a financial crisis. In February 2012, the European Central Bank and European Union, along with the International Monetary Fund, imposed a 53.5% haircut on all private bondholders -- for all practical purposes, that sunk the large Cypriot banks and manufactured their crisis.

Unlike the Federal Reserve, the European Central Bank lacks the authority to print money to rescue failing banks. European Banking Authority is an arm of the European Union, which lacks the borrowing authority of the U.S. Treasury and the taxing capacity to back up bonds. Hence neither the ECB nor EU is in a position to bail out the Cypriot banks without substantial contributions and consent from the largest and healthiest European economy, Germany.

Germany might be willing to extend ECB the authority to print money and the EU to borrow and tax to save banks in Frankfurt but not in Cyprus or just about anyplace outside Germany. Domestic politics prevent the German government from borrowing and taxing to bail out other troubled European banks and governments without extracting a high price from private actors. In Greece, those were private bondholders, which included banks spread throughout Europe but most heavily those in Cyprus.

Simply, Cypriot banks hardly have enough capital to cover their losses on Greek sovereign debt, and their economy is too small to afford the Cypriot government the borrowing and taxing capacity to rescue them.

In exchange for 10 billion euros in aid, the ECB and EU are demanding that Cypriot banks be downsized -- banking in Cyprus can be no larger than the average for the entire European Union. Moreover, under eurozone rules, championed by Germany, austerity -- cuts in government spending and strict limits on deficits -- will be required.