Did Cameron just lose a close EU ally?

Under its former ODS government, the Czech Republic, was a card carrying member of David Cameron's reform camp. Traditionally wary of "ever closer union", the Czech Republic refused to join the Euro, objected to the Charter of Fundamental Rights and, along with the UK, refused to sign up to the fiscal pact. All this combined with a shared economic liberalism made agreement easy. Unfortunately for David Cameron, they also failed to win an election.

The new Government is a very different creature. Formed from a Coalition of the Socialists, Christian-Democrats and the new insurgent Party ANO (Yes in Czech), the new finance minister has already dropped the former Government's principled objection to the Euro (although membership is still not an immediate likelihood), and now the leading candidate for the Human Rights Minister position seemingly wishes to abandon the country's semi opt-out from the EU's Charter of Fundamental Rights. With a one time self-described EU Federalist President (Milos Zeman) and a pro-integration foreign minister - the Czech Republic's direction of travel has certainly changed. It will likely be a big task for David Cameron to keep them onside.

Cyprus crisis shows Europe cannot perpetually move in one direction only

In an op-ed yesterday's Times, Mats Persson argued that:

No matter how the nail-biting drama in Cyprus ends, the eurozone has never been this close to waving goodbye to a member. Yesterday afternoon the deputy leader of the ruling party claimed that his country was hours away from agreeing an emergency package of tax rises and spending cuts to secure the EU’s €10 billion rescue loan.

If no deal is struck by Monday, the European Central Bank, on whose cash Cypriot banks depend, will pull the plug. With a banking sector seven times the size of GDP, Cyprus would default and probably crash out of the euro. The big question is whether a country can exit the euro without taking all Europe down. In the case of Cyprus the answer is straightforward: it could leave without causing a crisis, but it wouldn’t be pretty.

For Cyprus it would be extremely messy. To avoid massive capital flight there would have to be strict controls on financial movements, with border guards ready to stop people taking cash out of the country. After that would come a decree establishing a new Cypriot currency and a series of defaults on foreign debt. This would probably all have to be done in a weekend to avoid panic and contagion. A new central bank in Nicosia would fire up the printing press, which could trigger inflation. Cyprus could limp on with the help of external cash, possibly from the EU and the IMF or Russia — but it would be painful.

 For the rest of Europe there is a fear that a Cypriot exit could bring down Greece, Portugal, Spain or Italy. There are three ways in which contagion can spread: direct losses for banks or governments elsewhere in the EU start a chain reaction; depositors in other countries panic and cause a bank run; or nervous international investors fearful of losing out to the “next Cyprus” push the cost of borrowing up for other indebted governments.

But this is unlikely. Cyprus accounts for only 0.2 per cent of eurozone GDP, and vulnerable countries have little exposure to its economy. Greece would take a hit, but is already ring-fenced via EU bailout funds. Depositors in other countries have so far been unfazed by Cyprus’s troubles and even markets have been relatively calm. This suggests that Cyprus is a special, and financially marginal, case. In addition, the ECB’s promise to “do what’s necessary” to save the wider eurozone will provide extra reassurance to markets.

Instead the risks of a Cyprus exit are mainly geopolitical. The fear is that Nicosia turns to Russia for aid in return for, say, a Russian naval base on the island. Given its location, this would be a strategic nightmare for Europe.

To avoid such a scenario, it would be vital for Cyprus to stay in the EU, even if it left the euro. While life outside the EU may sound appealing to many Brits, it is different for a small open economy such as Cyprus. To complicate matters, EU treaties currently provide only a way to leave the EU (Article 50 of the Lisbon treaty), not the eurozone.

However, the EU specialises in legal acrobatics and there are articles in EU treaties that can be used for all kinds of purposes. One such clause provides a general legal base to achieve the “objectives of the treaties”, which include protecting the EU itself. It will be wrapped in a cobweb of legal jargon, but will effectively come down to a political decision by EU leaders.

And this is where it gets interesting for Britain. A Cypriot euro exit would have wide political ramifications: one of the founding principles of the EU — “ever closer union” — would be history. A swift, “Band-Aid” solution would almost most certainly have to be followed by a reworking of the EU treaties to recognise that the direction of travel is no longer only towards greater integration. The EU will have become a two-way street in which powers can be passed back to member states and its laws and institutions will have to reflect that.

Even if Cyprus does not leave the euro — and a revised bailout deal remains the most likely outcome — this episode signals that Germany and the other northern European countries are no longer willing indefinitely to foot the bill alone. At the same time the eurozone continues to lack the tools to deal with an acute crisis. This makes change almost inevitable for the way the eurozone is governed. Some governments have already called for a formal mechanism to allow a country to exit the euro. Europe cannot, perpetually, move in only one direction. And, in one way or another, Cyprus may be about to prove that.