Christine Lagarde, managing director of the International Monetary Fund (IMF), at a news conference following the Eurogroup meeting about Cyprus in Brussels, Belgium, March 25, 2013. (Jock Fistick/BLOOMBERG)

After contentious, marathon talks in Brussels that ended early on March 16, International Monetary Fund Managing Director Christine Lagarde applauded a Cyprus bailout package that taxed even the smallest bank depositors.

“I welcome the agreement ,” she said in a statement e-mailed shortly after midnight in the eastern United States, testament to another bleary-eyed euro summit. “The IMF has always said that we would support a solution that is sustainable, that is fully financed, and that appropriately allocates the burden sharing. I believe that the agreed package meets these three objectives.”

Behind closed doors, however, IMF had fought hard against aspects of the deal, arguing that a tax on insured depositors could damage the credibility of banks far beyond Cyprus. After a chaotic week in which that original deal unraveled and a new one was negotiated, some analysts say the events of the past two weeks could damage the IMF’s credibility and that of European policymakers, as well.

“That they get locked in an agreement they are fundamentally unhappy with is almost worse than walking out,” said

Howard Archer, chief European economist for the IHS Global Insight consulting firm. “They have got to be seen as doing something they believe in.”

Common currency hasn't delivered even economies

Though Cyprus is a small economy, the recent events are significant for what they show about the euro zone’s crisis and the management of it by the IMF, the European Commission and the European Central Bank — the “troika” responsible for negotiating euro-zone bailouts.

Nearly a third of the 17-nation currency union now has a rescue in place, with Greece, Ireland and Portugal receiving bailout loans and Spain overhauling its banking system. That alone speaks to the severity of a crisis that IMF and European leaders played down in the early months of 2010, when they hoped Greece would handle a developing government debt problem on its own.

In reality, the seeds of Cyprus’s collapse were planted by those very problems in Greece. The nation’s oversize banking industry invested heavily in Greek government bonds, and when those were slashed in value as part of Greece’s IMF-engineered rescue, Cyprus’s largest two banks were left essentially broke.

The heavy exposure to Greek debt developed under the watch of European bank regulators looking actively for stress in the financial system and of an IMF charged with hunting for and addressing potential instabilities.

The rescue program developed for Cyprus is modest in absolute terms, at about $13 billion. But it is the largest yet in the euro zone relative to the size of the nation involved, equal to about 60 percent of Cyprus’s annual economic output.

Within the top echelons of Europe and the IMF, the debate over Cyprus also exposed basic disagreements about the nature of risk in the currency union. That lack of consensus, three years into a crisis that has consumed top economic minds at the fund and elsewhere, is significant, and in this case led the needs of Cypriot and European politics to trump the IMF’s professional judgement.

The IMF viewed deposit insurance as an inviolable promise and has pushedin general for insolvent banks to be put out of business rather than bailed out by taxpayers. European officials, and particularly the leaders of Cyprus, were worried that closing a major Cypriot bank would lead to doubts about other weak European financial institutions and argued that a broadly applied deposit tax would pose less risk.

The original deal eventually unraveled through a combination of democracy and bureaucratic dictate. The Cyprus parliament rejected the deposit tax; the ECB then said it would cut off central bank funding for Cyprus unless it developed a new plan quickly.

For the IMF, it was a lucky set of circumstances. The final deal was more in line with its thinking — honoring the standard 100,000-euro government deposit guarantee and closing Laiki Bank.

The fund has been down a similar road before, enthusiastically backing a debt write-down for Greece in the summer of 2011 that its staff knew was inadequate. As with the original Cyprus plan, fund officials justified that stance as the best — or “least bad” — available choice.

Questioned about the gap between the fund’s public statements and private beliefs in Cyprus, agency officials focused on the future.

“What matters is the agreement that now has been reached,” said IMF spokesman Gerry Rice. “That’s where the focus should be.”