By Howard Schneider, Updated: Thursday, May 9, 10:05 PM

Cyprus seriously considered dropping out of the euro zone at the peak of its financial crisis in March as it faced a standoff over the terms of an international bailout, Cyprus Foreign Minister Ioannis Kasoulides said in an interview in Washington on Thursday.

The country’s leaders discussed severing ties with the 17-nation currency union for “24 to 48 hours,” after the parliament rejected an initial bailout plan, throwing the country’s economic future into doubt, Kasoulides said. “It was an internal reflection” about how the country should proceed, he said. “We had to think of all the plans B or C that existed.”

The exit idea was shelved after it was estimated that reinstating the Cypriot pound would have caused an immediate 40 percent drop in the value of the new currency, devastating a small island that relies heavily on imports.

Kasoulides’s comments give insight into just how perilous the past three years have been for the euro zone but also into some of the currency union’s underappreciated strengths.

A couple months ago Cyprus sent a quake through the world financial system. What has Cyprus done for us lately?

Given us an example of what a "bail-in" as unprincipled as previous bailouts looks like. Cyprus was supposed to be either a "one-off" or a "new template," depending on which European official you listened to. Either it would be a model for holding creditors responsible for the losses of banks in the proper legal priority, or it was a special punishment applied only to Cyprus because Cyprus is small and its banks contained Russian money.

Which is it? Increasingly, the latter.

A few weeks ago, the Central Bank of Cyprus published a curious set of "clarifications for the better understanding of the resolution measures." The principle of a bail-in—that uninsured creditors should suffer losses before taxpayers are on the hook—turns out to contain a few lacunae. "Financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, and educational institutions" will be excused from contributing to the depositor haircuts, though insurers later were removed from the exempt list.

That means, of course, the remaining depositors must take a bigger haircut.

Recently-elected president of the Republic of Cyprus (RoC) Nicos Anastasiades, elected in January 2013, spoke at Tel Aviv University’s Faculty of Law Tuesday evening following an official visit that included meetings with both Prime Minister Benjamin Netanyahu and President Shimon Peres. His talk was a full-throated call to nurture the budding friendship it has sparked with Israel despite the recent thaw in Israel’s relationship with RoC’s long-standing nemesis, Turkey.

With Israel and Turkey hopefully on the road to repairing relations, there are sure to be ramifications for international cooperation on the enormous cache of hydrocarbons discovered over the last few years beneath the seas of Cyprus and Israel. Cyprus might be edgy about where Israel’s loyalties lie. Perhaps this is part of the timing of the visit.

Cyprus became the new friend when Israel’s long-term partnership with Turkey was in the doldrums. The Republic of Cyprus was the perfect candidate for a rebound relationship: the country is the heart of a long-running conflict between Greece and Turkey, and between their respective ethnic kin on the island who are pitted against each other: Greek Cypriots in the “south” – the UN and EU member state known as Republic of Cyprus, and Turkish Cypriots in the north, who under the protective patronage of a Turkish military occupation (and in some ways, an economic one) since 1974, declared themselves the Turkish Republic of Northern Cyprus in 1983 – recognized only by Turkey.

In 1938, British Prime Minister Neville Chamberlain’s speech decided to ignore “a quarrel in a far-away country between people of whom we know nothing”. The world has now convinced itself that Cyprus is simply not systemically important. They may be proved wrong.

First, the package for Cyprus remains vague pending analysis by the Troika—the European Union, the European Central Bank (ECB) and the International Monetary Fund (IMF). Based on press reports of rising losses for the Cypriot banks, the problems may be worse than imagined, requiring changes to the bailout or making it unworkable. The Church of Cyprus is contesting the legality of some measures taken under the European convention of human rights which makes the expropriation of property illegal. There is a risk of further legal challenges.

Second, as with Greece, the package may not work. As in Greece and Portugal, privatisation proceeds and the revenue from increased taxes may not reach targets. The bank restructuring plan may not raise sufficient funds. It will encourage remaining deposits to flee Cyprus if and when capital controls are eased, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance.

Every so often, a moment comes along when you learn something important about how economies work. Thanks to the Euro area member states, we’re about to get one of these moments. Next week, we’re going to find out how people react when their bank deposits are at risk of being confiscated.

Faced with the prospect of having to lend €17 billion to Cyprus to bail out its banks, the Euro area member states had three choices: Lend all this money but have Cyprus default on its existing sovereign bonds, lend all the money on terms that make it clear you’re not getting it back or lend less money and let the banks default on their obligations.