Dollars and Sense: How little Cyprus had a big effect on the world's economy

Why Cyprus? Who would have thought a month ago that the tiny nation of Cyprus would be dominating the economic news in the way it has these past couple of weeks? Cyprus is a tiny island nation of only about a million people. And while it’s had its troubles throughout history, it’s been quiet and peaceful for the past 30 or 40 years. Its gross domestic product per capita, above the eurozone average at around $30,000, puts it among the richest nations in the world. So what happened there? For one thing, Cyprus put all its eggs in the banking industry. Banking dominates the economy. So the global financial crisis hit the country particularly hard. The crisis came to a head last summer when bonds were downgraded to junk status.

And why the ripple effects? There are two reasons the crisis in Cyprus has had ripple effects around the world. First, the country had become a tax haven for rich people of other countries, particularly Russia, but not just Russia. Secondly, the way the European Union handled this crisis was a bit awkward. One example: Dutch Finance Minister Jeroen Dijsselbloem, who also heads the eurozone’s finance ministers, said this week that when failing banks need rescuing, eurozone officials would turn to the bank’s shareholders, bondholders, and uninsured depositors to contribute to its recapitalization—as they’ve done in Cyprus. Using the Cyprus approach as a template would be a radical departure from current eurozone policy. When these comments went public on Monday, the Dow dropped more than 100 points in about an hour.

Crisis averted? Despite all that, things seem to have settled down in Cyrus. Banks opened on Thursday without too much turmoil. It will be a while before the country fully recovers. Thousands of Cypriots will lose their jobs as part of bank mergers that were a condition of the bailout. But it does—at least—have bailout funds from the other European countries, so it can start the rebuilding process.

Meanwhile, back in the United States. The U.S. economy continues to improve, though slowly. After that shaky Monday I mentioned above, stocks continued strong. The S&P 500 had been flirting with an all-time high for several weeks, and on Thursday it finally got there, closing at 1,569. Today also marks the end of the first quarter, and it was the best first quarter for the stock market since 1998, and one of the best first quarters in modern stock market history. The S&P was up nearly 10 percent, for example.

But how do we know this isn’t another bubble? We don’t. In weeks past, and in a profile I wrote on Ben Bernanke, I talked about the phenomenon of asset inflation. It’s the idea that even in a sluggish economy, when prices aren’t rising, assets like stocks and real estate will increase in price to reflect diminished confidence in the long-term value of the dollar. We got another sign of that this week when the government reported U.S. single-family home prices rose in January at the fastest pace in more than six years. If you own a home, that sounds like good news. In fact, it may be. Housing prices had been beaten down so much that this could be a legitimate recovery. Also, we received a report this week that durable goods orders shot up in February. So there is some reason to believe that the stock rally is based on real economic growth, and is not just an early sign of the inflation to come. But the truth is that it is still too early to tell.