Cyprus risks deepening the eurozone crisis as austerity is failing across the continent. This is a tide that has to be turned

Europe’s flesheaters are back. The claim that the worst of the eurozone crisis is behind us now looks foolish. The deal forced on Cyprus by the German-led Troika at the weekend isn’t a bailout: it will effectively destroy the island’s economy. Instead of getting a grip on its grossly inflated banks, it will impose a brutal credit contraction, combined with sweeping cuts and privatisations, wiping out perhaps a quarter of Cyprus’s national income. Ordinary Cypriots, not Russian oligarchs, will pay the price.

Of course Cypriot politicians are to blame for having allowed the country to be turned into an adjunct of a bloated financial sector and a refuge for hot Russian money. But what tipped the divided island over wasn’t foreign investors’ sharp practices, but the impact of Europe’s wider crisis on its banks: in particular, their exposure to devastated Greece, currently also in the Troika’s tender care.

Some have hailed the fact the raid was carried out on Cypriot bank deposits over €100,000, rather than the public purse. At last the rich and those responsible for private banking failures are being made to cough up, it’s been said. Which would have been a good thing. But it’s savers, not bankers or shareholders, who are taking the 40% hit. And many of the targeted depositors, such as pensioners, are scarcely rich – or are small businesses which will now go bust.

The Cypriot government should instead have learned from Iceland: taken over the banks, isolated the bad loans, protected deposits, imposed losses on the wealthy, and used a publicly owned banking sector to rebuild the domestic economy. That would have offered its citizens a better future, almost certainly outside the eurozone. But it would have also encroached on private capital’s privileges and clearly couldn’t be tolerated. Instead, in classic EU style, Cypriots have been given no say, while German MPs vote on the deal. Meanwhile, Cyprus’s banks are still closed and capital controls will start to erode the euro as a genuine single currency. As the Greek economist Costas Lapavitsas argues, Cyprus has “reactivated” the European banking crisis.

Not that it had been resolved. Only last month the Dutch government was forced to nationalise the Netherlands’ fourth biggest bank, SNS Reaal, partly because of its over-exposure to losses in Spain. But since the European Central Bank president Mario Draghi pledged last year to do “what it takes” to save the euro, market fever had subsided.

Now the Troika’s decision to help itself to Cypriot savings has paved the way for a new contagion. In the short term that may be contained because of the island’s minuscule proportion of eurozone output. But the move has demolished confidence in bank deposits – a point rammed home by the Dutch finance minister’s blundering signal that the deal had set a precedent. That could easily turn into bank runs in states likely to need new bailouts, as investors move cash to safer locations. Given the spectacular failure of austerity across the continent to overcome the crisis, rather than deepen it as output shrinks and debts mount, more such breakdowns are clearly on the cards.

The eurozone has now become a zombie zone. And any further deterioration can only deepen Britain’s own crisis. Whatever the focus of the meltdown in each country – banking in Cyprus, property in Spain – all flow from the same crisis that erupted in 2007-8 out of a deregulated profit-hunting credit boom across the western world and has delivered a prolonged depression. In the eurozone, the impact of that systemic failure is made worse by a lop-sided one-size-fits-all currency straitjacket that was always going to come apart under pressure. In Britain, the power and weight of the City of London are a particular block on sustainable recovery.

But across Europe, people are being held to ransom by banks, bondholders and corporations determined to ensure that it’s not they who bear the costs of the crisis they created – and politicians who regard it as their job to oblige them. So even though Britain is facing the threat of a triple-dip recession, George Osborne last week ploughed on with a regressive austerity programme that is manifestly failing in its own terms but offers lucrative corporate opportunities in the spaces opened up by the rolling back of the state.

Next week some of the Cameron coalition’s most brutal cuts will kick in – including the deeply unpopular bedroom tax – just as anyone earning over a million pounds a year gets an annual tax cut of at least £42,295, and local councils face the loss of a third of their budgets by 2015. Resistance to death-spiral economics is hardening across Europe, but so is political polarisation. Alexis Tsipras, leader of Greece’s radical left party, currently leading in the polls, compares the situation to prewar Weimar Germany. Cameron is not the only leader using anxieties over migration to deflect anger at the impact of his own policies.

In Britain, public opinion has long balked at the government’s cuts programme and is now increasingly opposed to attacks on welfare. That mood was reflected in last week’s rebellion by 44 Labour MPs against their leaders’ decision not to oppose retrospective legislation imposing benefit sanctions on unemployed people refusing private “workfare” schemes. Today unions and community groups launched a national “people’s assembly” to mobilise against austerity. One way or another, resistance has to get stronger – or they’ll devour us all.

Twitter: @SeumasMilne