Europe's latest bailout news has reminded us of something we'd all forgotten: Cyprus is a member of the European Union. Like many of those European states running a Mediterranean economy with a Baltic currency, they've fallen on hard times of late. Specifically, their large banks held a lot of two things: Greek government debt and Russian tax evaders' deposits. The failure of the former put the latter at risk, while also imperiling the deposits of your average Cypriot.
And so, rather than let a bank fail and have the bank's bondholders and shareholders lose money (never!) the Cypriot government nationalized one bank and bailed out some more. That didn't solve the problem, it just moved the bad debt from the banks' balance sheet to the taxpayers'. So, one bailout begat another. The European Central Bank agreed to bail out the Cypriot government and the remaining independent banks. [A fuller explanation is here, if you want more details.]
The cause of most of the stink was that the plan from the ECB called for a novel funding source: a "tax" on the deposits held by the banks. Although EU citizens have deposit insurance similar to our American FDIC, it seemingly wouldn't apply here, leaving depositors to lose 6.75% of their insured savings and a larger percentage of any savings over the insurance limit (€100,000). As you'd expect, this didn't go over well, and the Cypriot parliament unanimously rejected it.
So, that's where we stand. But beyond this current crisis, the entire island of Cyprus represents a slow-motion crisis that's a century old. The British "leased" Cyprus from the Ottoman Turks in 1878 as payment for supporting the Turks against the Russians at the Congress of Berlin. The island remained Ottoman territory, but the Brits ruled it. When the two nations went to war in 1914, the British made it official and annexed Cyprus. The population was mostly Greek, but a significant Turkish minority lived throughout the island, as the maps here suggest. In the aftermath of the First World War, the Ottoman Empire fell and a Turkish Republic took its place, much reduced in size. Areas of Thrace and Asia Minor that held mixed populations of Turks and Greeks saw years of conflict that only ended with a 1923 convention mandating population exchanges. Turko-Greek relations were far from perfect thereafter, but irredentists on both sides no longer had cause to attempt annexations of their former enemies' territories.
Cyprus, immune from the wars under British ownership, did not suffer any of this strife. But neither did they resolve any of the hatred or distrust between the two ethnic groups on the island. By the 1950s, the Greek majority was agitating for independence and enosis, or union with Greece. Many Turks wanted independence, too, but with a part of the island to be united with Turkey. The British resisted both, but agreed in 1960 to free Cyprus as a separate state in which Turks and Greeks co-existed and governed together.
You can see where this is going.
By 1963, there was widespread ethnic violence as each group agitated for their own idea of reunification with the motherland. In 1974, the Greek army engineered a coup and the Turkish army invaded to prevent the planned enosis. The result was a de facto partition, with the Turkish army occupying the northern 40% of the island and a rump Greek Cypriot government holding the remaining 60%. Most commentary on the latest crisis has not remarked on this fact, and the word "Cypriot" is used to refer to the just-over-half of the island governed by the Greek Cypriot government. The Turkish part, which calls itself the Turkish Republic of Northern Cyprus, is recognized by no nation beyond its Turkish progenitor and, so far as I can tell, has no problem with its banks.
There have been several attempts since then to re-unify the island, including most recently a plan by former Secretary-General Kofi Annan that was accepted in a referendum in the Turkish half, but rejected in the Greek half. Despite this unresolved territorial problem, the Greek half was admitted to the EU a week later, thus involving the whole of Europe in the First World War's remaining squabble.
While I admire the Turkish Cypriots' optimism and good faith, it was probably right that the Annan plan should fail. It would have only resurrected the co-habitation of two peoples determined to separate; a Bosnia-Herzegovina with better climate. Neither of these peoples wanted a Republic of Cyprus; the only dispute was over which nation would annex them. In 1960, this was a thorny problem, since the people were thoroughly intermingled, but the Turkish invasion, condemned as it was by idealists around the globe, merely enacted in 1974 what the rest of the former Ottoman empire sorted out in 1923. The Annan referendum failed, but I'd bet a referendum for enosis would be quite successful. A referendum in the north to join Turkey would likely succeed, too, especially since the Turks have filled their side of the island with settlers from the mainland over the last 38 years.
Would this solve the bailout problem? Not really. Matt Yglesias, in an article heavily derivative of my tweet to him yesterday (screenshot below), suggested that Turkey buy the north from Cyprus, thus getting the much needed cash to the [Greek] Cypriot government. But that still leaves the rump Cyprus independent and broke, (though slightly less broke) with a bunch of banks propped up by Russian gangsters' deposits. So here's a better idea, one that should've been done in Ireland, Greece, and America, too: let the banks go broke. Deposit insurance will protect the small accounts (if you even consider €99,999 small). People who had more than that may lose. So may the banks' bondholders. Why do you think the rates were so high? That's risk, friends. True capitalism requires the ability to fail, not just the ability to succeed. The current "solution" has already triggered a bank-run; how much worse could this be?