The Central Bank 'Improvisers'

The bailout of Cyprus - if it can be called that - bore all the trappings of Europe's standard response to its economic crisis. The last-minute, melodramatic rescue was complex, contentious and controversial. Decisions were taken that, for now, prevent Cyprus's problems from spilling over to the 16 other countries that use the euro. But the same steps may make matters worse in the long run. No one who reads Neil Irwin's splendid new book, "The Alchemists: Three Central Bankers and a World on Fire," will be surprised.

Most accounts of the crisis have treated it mainly as an American affair. Irwin departs from convention by recognizing it as a global event and focusing equally on Europe's turmoil. The title refers to the medieval chemists and con men who tried to convert everyday materials into gold and silver. Irwin's modern alchemists lead the Federal Reserve, the European Central Bank (ECB) and the Bank of England. But he could also have called his book "The Improvisers." For improvisation is how they've reacted to today's turbulence. (Disclosure: Irwin, a Post columnist, is a colleague.)

At every stage, their solutions have been makeshift, hasty and sometimes desperate. Policies often fix immediate problems but threaten to cause - or seem to threaten - larger future problems. The constant goal, as Irwin shows, has been to prevent a collapse of the global financial system, which could plunge the world economy into a genuine depression. Everyone embraces the goal, but the responses have often been expedient and inconsistent.

Certainly, this verdict applies to Cyprus. The threat was that it would be forced to abandon the euro and that its exit would trigger contagion. Bank depositors elsewhere - Italy and Spain being obvious candidates - would withdraw their euros to prevent them from being converted into cheaper national currencies. So Cyprus became significant well beyond its tiny size. It symbolized the willingness of other euro-zone countries to defend the currency. Here's why.

Unless Cyprus's loss-ridden banks were recapitalized, they would have had to close. Without credit, businesses wouldn't have been able to pay their bills. Lacking the 10 billion euro ($13 billion) rescue, the government would have defaulted on its debts. The only practical alternative would have been to jettison the euro and resurrect its own currency, which it could have issued in unlimited quantities.

But the cure is almost as bad as the disease. To recapitalize banks, depositors with more than 100,000 euros ($130,000) - the amount protected by government guarantees - are being forced to take huge losses. This is a first. Until now, depositors in weak banks had been protected. If depositors elsewhere in Europe fear for their funds, the dreaded panic may merely be delayed. And with unemployment already at 14 percent, Cyprus's economy will get worse. Some forecasts predict it will shrink 20 percent by 2015.

The "alchemy" of central banks is that they can create as much money as they please. The question is whether this power can be mobilized to stabilize financial markets and revive the damaged European and U.S. economies - or whether the frantic efforts to do so founder on high debt, too much "austerity" or uncertainties about economic growth and inflation.

Each central bank has "taken steps beyond any it would have considered possible a few years earlier," writes Irwin at the end of his gracefully written and exhaustively reported book. The Federal Reserve has poured trillions of dollars into the U.S. economy through various "quantitative easing" programs. The Bank of England has made similar efforts. The ECB has buttressed Europe's financial markets by providing gobs of cheap credit to banks and by pledging, under specified conditions, to buy the bonds of beleaguered euro countries.

What unites these policies is an unstated play for time. The hope is that at some point economic demand from somewhere - countries' own consumers and businesses, China, Germany or who knows where? - will support self-sustaining recoveries.

Meanwhile, the longer weak economies and high unemployment persist, the more democratic countries see power shifting in undemocratic ways. It has moved to volatile financial markets and to central banks, with unelected leaders. The ECB in particular, Irwin relates, has withheld aid until governments do its bidding. This cannot be healthy, although elected officials often seem paralyzed because either they don't know what to do or lack a consensus to act.

So far, improvisation has avoided the worst. It may not forever.