The eurozone is facing its biggest challenge since its inception.
Cyprus is the second-smallest economy in the common-currency area, but the reverberations from its bailout crisis are being felt across the continent. Average citizens in Europe's periphery nations are outraged. Germans and other core European citizens don't want to fund their less-responsible neighbors. And risky banks in Cyprus and other nations, facing unsustainable futures, teeter on the edge of insolvency.
Cyprus may have found a way out of its imminent crisis by agreeing to a bailout solution on Friday, but the danger's not over in Europe. While U.S. investors hardly need to start worrying -- after all, Cyprus is a tiny portion of the EU's economy and the Dow Jones Industrial Average (DJINDICES:^DJI) is still happily surging to record highs -- any spreading of the European contagion to larger, more powerful economies could lead to dire economic straits.
We're now almost out of default-watch as Cyprus' politicians came to a deal to save the island nation from a financial implosion on Friday. Cyprus intends to restructure good and bad banks without crushing depositors, as the original plan that caused all this uproar would have done.
Cyprus' lawmakers also set up a "solidarity fund" for future crises, along with placing a restriction on financial transactions in any similar times of hardship that occur in the future. The country needs to come up with 5.8 billion euros in all for the EU to provide its pledged 10 billion-euro bailout, although one plan being floated around that's sure to spark more anger among average Cypriots would tax all bank deposits at a much lower rate of less than 1%.
It's not anywhere near the earlier rates lawmakers floated. That's unlikely to placate incensed Cypriots, however, considering average citizens have expressed outrage among any taxation of previously guaranteed deposits under 100,000 euros. Cyprus' politicians may be forced into coming up with a less provocative resolution.
Greece is lending a hand, for its part. The debt-plagued nation had to help, as its own fragile financial stability rests upon stopping any signs of bank runs or other problems before they spread, especially with Greece's own citizenry disgruntled at Germany and other core nations in the eurozone.
The Piraeus Bank of Greece is slated to assume control of local branches of Cypriot banks to protect Greek customers, in hopes of stemming any panic among average Greeks fearing for their deposits. But will these measures be enough to restore the shaken confidence of average citizens across Europe?
Will the infection spread?
Cyprus got into this situation in the first place by letting its financial sector run wild. The country's banking sector swelled far beyond its GDP, and when the banks inevitably failed, there was no chance the Cypriot government would be able to save the nation from financial turmoil. That's not the fault of the eurozone, and one can't blame Germans and other core lender nations if they grumble about coughing up the whole bailout bill.
Similarly, you can hardly blame average Cypriots for expressing outrage at the earlier proposed deposit levy. While fellow analyst Morgan Housel correctly points out that the cost of leaving the eurozone would cripple Cyprus far worse than the levy would, average citizens are hardly responsible for Cyprus' debt situation. Shredding any semblance of deposit guarantees and demanding more from the common people -- rather than hitting large bank accounts from wealthy foreign depositors -- would never be accepted with open arms.
But Cyprus isn't the only country facing unsustainable levels of debt -- and the other peripheral European nations on the brink of disaster would hit Europe with a much bigger hammer.
A lot of talk has been floated over Greece's debt problems, but in comparison with the eurozone, the Greek debt is hardly influential enough to induce panic. Greece also isn't a tax haven for wealthy individuals looking to deposit cash in its banks, but the country's not entirely on stable footing. The Greek populace has already exploded over Germany's intervention in its bailout in a similar (but more violent) pattern to what happened in Cyprus' streets. Meanwhile, the National Bank of Greece (UNKNOWN:NBG.DL) took big hits after restructuring following last year's austerity measures. However, Greece is small enough in the big picture that, while it's vulnerable to instability, it's not likely to rock the European boat too hard.
Nor is Spain: While the Spanish financial crisis has sparked massive protests in the streets and even a separatist movement in Catalonia, the country's banks are on good footing. Institutions such as Banco Santander (NYSE:SAN) aren't in trouble like Cyprus' imploding banks are; Santander in particular has done a spectacular job diversifying into growing markets in Latin America and elsewhere worldwide, rather than consolidating too heavily in economically crippled Spain.
No, the real problem is Italy. There's virtually no way to save this bloated economy if it runs into its own imminent debt crisis; Italy is the eurozone's third-largest economy, and even frugal Germany couldn't ride in to save the day in this case. Italy also isn't in as dire a situation as Cyprus' banking sector was, but the political mess that is the country's leadership hardly inspires confidence. If the problems that have already hit Greece and Cyprus spread to the Italian peninsula, Europe will be sunk.
It thus seems a great time for the eurozone to enact changes to its bailout program -- but the fundamental nature of the EU makes this a tall order.
The problem with change
In nations such as Japan, the U.S., and the U.K., governments have the unpopular but valid option of printing money to solve financial messes. It's still a haircut on average citizens if said printing leads to inflation, but it's one less likely to stoke the masses into protests (or worse). After all, the number in the bank account doesn't change.
But Cyprus, Greece, and Italy don't have that option under the common currency of the eurozone. These countries are forced into relying on creditor nations within Europe, such as Germany, to solve their problems via bailouts.
Ask Angela Merkel how she feels about paying to save other countries. At a meeting of her parliamentary faction this week, the German chancellor was reportedly furious at Cyprus and its handling of the crisis. Merkel's looking for re-election later in the year, and average Germans want no part of paying for Cyprus' woes while Germany remains a beacon of financial responsibility in the eurozone.
Yet the lack of communication between nations that ostensibly are partners has created a toxic relationship between countries. Many average Cypriots point to Germany and Merkel as responsible for the deposit levy idea even though Cyprus' government was the one to come up with it. Greeks similarly pin the blame of their flailing economy on Germany, the easy target that has demanded conservative austerity measures from hard-hit economies.
This trend will continue until the eurozone establishes some sort of stronger central control mechanism. Getting nations that don't see eye-to-eye on policy to cooperate in this loose union has failed abysmally. Deploying measures such as the proposed bank levy will only kill the already-waning faith of average citizens in the eurozone's strength.
Until that happens, the eurozone's instability and debt nightmares will continue to shake investor confidence in Europe and beyond. Cyprus' economy wasn't enough to shake investors out of the recent highs the Dow Jones and other indices have climbed to, but any worsening or spreading of the crisis could lead to widespread concern. It's imperative that the eurozone finds a common ground to restore solidarity between member nations and solidify its bailout controls in a way that won't cripple the financial freedom of average Europeans.
The eurozone's future is riding on it.
Fool contributor Dan Carroll and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.