The severity of the economic problems in Cyprus puzzles me. When my World Bank colleagues and I were working on Cyprus in the 1980s, we were favourably impressed by our Cypriot counterparts, both in the government and in the private sector.
They showed good sense and were always willing to listen to suggestions.
They were optimistic but cautious, knowing that as a small country in that particularly volatile region, Cyprus could be vulnerable to even relatively minor shocks.
With appropriate policies and hard work by the people, the economy recovered remarkably well and grew briskly after the partition of the island in 1974, so much so that it ceased to be a developing country quite quickly and joined the European Union (EU) in 2004.
True, Cyprus's economy was badly affected by the external shocks created by the series of crises hitting members of the EU, particularly Greece. But why did government officials think that they could get away with large budget deficits and Cypriot banks put so many eggs in the Greek basket?
Obviously, the government got away with violating the toothless EU stipulation of not allowing the budget deficit to rise above 3% of GDP, but not with the laws of economics: four years of large budget deficits varying between 5.3-6.3% of GDP have put the government in a financial bind.
In the case of banks being highly exposed, many factors could have played a role.
Fundamentally, the Washington Consensus perhaps is the one that should take a major share of the blame, for it continues to preach the wonders of the market's ability to regulate itself. The Cypriots have listened all too well to that preaching, although their economy has been already highly market-oriented and financial crises in many countries over the past three decades should have shown them that the market cannot adequately regulate itself.
And it is the Washington Consensus that allows those with expertise in the "alchemy of finance" _ with apologies to George Soros who employed this term as the title of his first book and its mechanism to make billions of dollars _ to generate so much wealth by shuttling funds among themselves. Remember the CDOs?
As a result, the role of the financial sector in the economy has significantly increased and it has become in effect the tail that wags the dog. In the case of the United States, the financial sector's share of GDP has doubled since the Reagan-Thatcher era began. Efforts to tighten regulations on activities have been largely thwarted by their financial clout and political allies, especially those who continue to worship market fundamentalism. In the case of Cyprus, total assets of the banking system rose to about nine times GDP two years ago; compare this with 3.3-3.6 times for the EU and the eurozone.
One may also attribute the problems to problems with the growth model used by Cyprus and many other small economies: setting up a financial centre to generate significant income from large inflows of foreign funds, including from sources that could have earned such funds by shady means.
The financial sector may indeed create substantial employment but it is also under great pressure to lend the funds, while it is short of ability to assess risks, particularly in the areas that it has insufficient expertise.
Cypriot banks might have tried to make up for this shortcoming by putting an unduly high proportion of funds in Greek assets that they believed they knew well. One may also attribute the problems to so much wealth in the form of liquid funds floating around the globe. Such wealth is generated partly by Americans continuing to consume at an exceptionally high level, leading the US to incur large foreign sector imbalances which are financed by printing more dollars. And, of course, fraud could have been a factor. Although not yet proven, financial authorities are reported to be looking into banks giving favourable treatment to politically connected entities and individuals.
The Cypriots were warned by their own compatriots before their country became virtually bankrupt. Among them was the World Bank's Constantinos Stephanou, who sounded the alarm in his paper published in the Cyprus Economic Policy Review in 2011. Perhaps I do not know the Cypriots as well as I thought, despite working with them for many years, they are in one respect like the Thais _ we rarely listen to suggestions and ideas that come from our fellow countrymen.
Sawai Boonma has worked as a development economist for more than two decades. He can be reached at sboonma@msn.com.