Cyprus- Why Krugman got it wrong

Much like the the last time I disagreed with Krugman, disagreement is of the “yes, but” variety. The last time, he was telling off austerity, but I doubt he had in mind economies in which (shockingly wasteful) state spending reaches 54% of GDP. This is taxes and spending on a very long list of things like the 42 architects employed for 30 years -with regular pay hikes and promotions- to build dams.

We were done building dams 20 years ago.

Likewise, everything he says about Cypexit, stands correct on its face. There is no doubt that the Euro translates to deep recession for Cyprus, especially after the horrific Eurogroup idea to propose losses on depositors in order to stave off a banking crisis. I’ve wondered before if this was sheer stupidity or bad intentions.

But then again, Krugman suggests that “leaving the euro, and letting the new currency fall sharply, would greatly accelerate…rebuilding.” Well, it does, usually. Except, there are a few concerns in the case of Cyprus.

Bailed in…

All of Cyprus’ physical inputs are imported. Everything; from feed to steel and from fertilizers to computers. Raw materials are imported. Intermediary goods are imported. Capital goods also imported.

This is an island economy with a GDP smaller than Vermont and a population 200.000 short of a million. So, when I say, “imported”, I mean “close to 100%”.  While the primary surplus that Krugman mentions is a 2013 projection unlikely to materialize (again), the trade deficit spikes with GDP growth and declines rapidly with recessions. This is not unusual, and Krugman would say that it reflects FDI flows as well. But a closer look reflects the extreme dependence on imported factors of production.

This changes the entire picture and makes one wonder about the level of inflation under a new currency, as well of the impact that this would have. All of the obvious concerns about a nascent currency borne out of crisis are suddenly multiplied into a nightmare.

In fact, as if all of this weren’t enough, note that Cyprus is also 100% dependent on energy imports. Gas prices have been rising at a dizzying pace in the last two years, although from a lower starting point than in most other countries. Electricity is another issue –prices accurately reflect how profoundly reckless Cyprus has been in managing its infrastructure: We managed to blow up our main electricity plant by storing munitions outdoors, nearby. Ever been in Cyprus in the Summer?

Krugman notes that Cyprus has two main exports- tourism and banking services. And, he is right in saying that banking was wiped out overnight, at least as export. On the other hand, the main question about tourism isn’t so much whether a devaluation will help the industry; of course it will.

The question, though, is more basic than that: After the glorious 1980s, can the industry be revived? One wonders, after the sun-sea-and-sex tourist wave 30 years ago, what the prospects are for Cypriot tourism. With a few bright and special exceptions, the industry has been in a steady wane since the early 1990s.

Already, its share of the GDP has declined significantly. But more importantly, lower-end hotels have been sitting idle for years. Upper-end hotels have been lingering between high debts on the one hand, and declining quality on the other.

Part of the explanation why this happened, is that most hotel owners were too busy frantically building mansions for British retirees- and in the process unwisely taking massive loans that the banks unwisely extended to them. This was a traditional banking fumble, where real estate loans were based on collateral: The real estate development itself. But that’s another story.

The problem with Cyprus tourism is that supply is too massive and quality is too low. What it needs is fewer and better hotels. Krugman makes a reasonable point and he had no way I can think of to examine the industry. Besides, this is not macroscopic analysis; this is formerly five-star hotels with chipped ceilings and decaying swimming pools. The ones making profits in the last years are the exception. The competition –Egypt, Israel, Turkey, Greece- have more and better hotels. Oh, and more and cheaper flights, not to mention better overall service.

So even this hope is far from likely to come to anything.

All of this, of course, comes on top of the traditional concerns about currency devaluation. And it comes with none of the perks. In fact, the very vibe in the international markets right now makes the Central Bank’s total reserves a very much relevant issue: A total of 19 billion euro, not enough to squeeze a single bear, let alone hold off for anything resembling an attack on the new currency.

So Cyprus is one of those places that will have to slug it out.

And slug it out we will.

There are lots of good ideas, even investor interest, for new industries, for better and more orthodox government action and for ways to give growth a nudge.

Above all, a new currency would be the easy way out. And, by now, we Cypriots ought to know pretty well where the easy way leads after a while.