There has been a lot of negative comment about the Cyprus deal. That is understandable: you can reasonably argue that imagesit will produce crippling austerity; that it is ridden with moral hazard; that it will create a bank run across most of Southern Europe. But what you can’t argue is that it was unexpected.

Too understand the deal in-case If you are in Cyprus :
* You can put money into your bank, but you can’t get it out again. At least you can, through ATMs, but only in very small amounts.
* If you have money on deposit, you can’t take the money out and close the account. And if it’s a time deposit, when it reaches the end of its life, you can’t have the money to spend. You have to roll it over into a new deposit.
*You can’t cash a cheque in a high street bank. You can’t pay bills in a high street bank, either. And no high street bank is lending any money, so if you want a loan, forget it. In fact high street banks are not much use.
* If you have more than one account, you can’t transfer money between your accounts. If only one of your accounts has ATM access, once that account is empty, you are stuck with no money.
*All the local shopkeepers will only accept cash, not cheques. That’s because they have to pay suppliers in cash, and once you put money in a bank, you can’t get it out again…..But all small businesses are having a very hard time. Shops are closing, businesses going bust, people losing their jobs.

The above is a description of the effects of the capital control bill forced through the Cypriot parliament this weekend. From Tuesday, Cyprus becomes a black hole in the Eurozone: any money that goes into it stays there, and no money can leave……From a safe distance, it will appear frozen in time, a small cash-based economy, isolated from the rest of the EU. While inside, invisible to all except those who actually go there – or live there – its social fabric is torn apart as its economy collapses. Note the final clause in the capital control bill.

The IMF acknowledged in a paper a few months ago that capital controls can be helpful in crisis-hit economies. In Cyprus’s case, the immediate need for capital controls is to choke off bank runs when the banks reopen after the extended bank holiday. The trouble is that bank runs are not necessarily acute. As we have seen in other countries, notably Greece and Spain, bank runs can be silent and extended. Even in Cyprus, deposit flight started some time before the attempted depositor haircut last week that forced closure of the banks. It is difficult to see how, with a wrecked financial system and collapsing economy, capital controls can be lifted at all without setting off bank runs. As things are set to get much worse, probably including bank failure and sovereign default in the not too distant future, capital controls are likely to remain in place for a long time. Despite the IMF’s insistence that capital controls should be short-term, recent use of them has been anything but: Iceland has now had “temporary” capital controls for five years, and Argentina for ten (although that is probably for political reasons). Dismantling capital controls is not easy.

But the Cyprus capital controls differ fundamentally from those imposed in the Iceland banking crisis. Iceland is a sovereign state with its own currency. Cyprus is a member of a currency union – the Euro. And capital controls make a complete nonsense of currency union.

Once full capital controls are imposed, a Euro in Cyprus will no longer be the same as a Euro anywhere else in the Euro area. It cannot leave the island. The Cyprus Euro will in effect be a new domestic currency. The imposition of capital controls in Cyprus is therefore the end of the single currency in its present form. As this image shows, the single currency will have a bit missing – a bleeding chunk torn from its edge:

 

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