Another country has dug itself into a hole, and with a banking crisis on its hands tiny Cyprus finds itself garnering out-sized attention. Here are two key lessons for the United States and the rest of the world.
Capital is Not to Blame
Despite providing yet more evidence for the direct connection between big government and profligate spending on the one hand (more on that below), and national economic crises on the other, the usual suspects are spinning the Cypriot crisis as proof of a need for more taxes, spending, regulations and controls. And it's no real surprise that Paul Krugman seems to be leading this bonehead brigade.
In a recent op-ed, Krugman tried to blame the Cypriot crisis on the tiny-island's status as a so-called “tax haven.” Yet all he offered to advance this thesis was to point out that Cyprus attracted a lot of foreign investment, which provided them money to spend poorly. The problem, he says, is that “enough real money came in to finance some seriously bad investments,” because “the country is a tax haven where corporations and wealthy foreigners stash their money.”

By Krugman's logic, the only solution is just to be poor.
After all, it doesn't matter how they made their wealth. Whether they acquired their capital by attracting foreign investment (something the U.S. is also quite good at) or by manufacturing the best widgets in the world, the point is not simply that they had it, but that they foolishly used it to purchase Greek debt.
Just maybe the problem isn't that Cyprus was becoming prosperous, but that their banks squandered that prosperity on the junk bonds of another profligate government.
In addition to wrongly blaming the efforts of Cyprus to attract capital, the necessary lifeblood of any prosperous economy, Krugman also celebrates the likely imposition of “fairly draconian controls on the movement of capital,” while glorifying the good ol' days when “limits on cross-border money flows were widely considered good policy.” You know, back before “the rise of free-market ideology,” capital mobility, and the rapid increases in global wealth and prosperity seen over the last half century.

Big Government is a Bad Bet
If merely increasing access to capital is not responsible for current Cypriot woes, then what is? In more ways than one, the answer is excessive government spending.
As even Krugman acknowledged, Cyprus banks erred in acquiring Greek debt, where the problems caused by runaway government spending have been well covered. Banks making such a bad bet deserve to fail, but it turns out they weren't the only ones betting on big government. So too were politicians in Cyprus.
Although the financial situation is the catalyst for the current crisis in Cyprus, the country was already on the path to ruin. Since the mid-1990s, the burden of government spending in Cyprus averaged 8.3% yearly growth, climbing from about 34% of GDP to around 47% today. As Dan Mitchell noted last summer, if Cypriot politicians had merely limited the growth of government to 6% annually over that same period, the burden of government spending would have remained at 34% and today they'd have a large budget surplus, rather than a debt-to-GDP ratio that hit 127% in the third quarter of 2012. A sound budget would in turn have allowed them a much wider range of options for dealing with trouble in the financial sector without begging their neighbors for a bailout.

It's their fiscal insolvency that has ultimately boxed Cyprus into a set of equally bad solutions. Had their government spent more responsibility, depositors could have been shielded from the mandated “haircut” that caused a banking run, and much of the pain and turmoil seen in recent weeks could have been avoided.