The banks are open again in Cyprus, after nearly two weeks of being closed, though good luck getting your money out. Capital controls in place to restrict what would be a gush of funds out of the country to a trickle.
The president of the Mediterranean island said Friday that “We have no intention of leaving the euro,” that is dumping its membership in the 17-nation currency union that Cyprus only joined in 2008. “In no way will we experiment with the future of our country," said Nicos Anastasiades.
I would argue that Cyprus was experimenting with the future of the country when it entered the Eurozone, but that’s an argument for a different day. The question facing Cyprus now—and which its leaders have apparently answered with a resounding no—is whether leaving the euro altogether and issuing a new version of the Cypriot pound would be the best path forward for the nation.
Paul Krugman summarizes the case for a euro exit here. “The convenience and efficiency of a single currency is gone; meanwhile, the future for Cyprus on the euro is one of years of grinding deflation and catastrophic austerity. Is the hope of someday, somehow restoring the status quo ante enough to justify all of this?” he writes.
Think of it this way: Cyprus has now crossed the Rubicon of seizing large bank depositors’ funds, and it has crossed the Rubicon of putting in place capital controls, essentially prohibiting people from taking money out of the country (these airport signs prohibiting people from carrying more than 1,000 euros on an outgoing flight are only the most visible piece). So for practical purposes, Cypriots are not in the currency zone now.
In other words, many of the biggest benefits of being part of the Eurozone have evaporated for Cypriots. Euros stuck in Cyprus are not terribly useful for engaging in trade with the rest of Europe, or for protecting the small country against being buffeted by the waves of the global economy.
Meanwhile, the Cypriot economy is all but certain to enter depression in the months and possibly years ahead, as its government slashes spending and foreign investment dries up. But because it will remain on the euro (if a hobbled version of it), Cyprus will not have one of the pathways to recovery that other small countries that experience a financial collapse have at their disposal.
Normally, when a small country’s banking system collapses, so does its currency. No one would argue that this is a good thing: It means the country’s savers are wiped out and imported goods become much more expensive overnight. But it also sows the seeds of a recovery. If a currency falls by 40 percent, suddenly the country’s exports are 40 percent more competitive, tourism to the place is 40 percent cheaper, and anyone thinking of investing in the country can get labor for 40 percent less.
That helps explain the difference between, say, Iceland and Ireland. Iceland experienced a banking collapse in 2008 during which its currency fell in half, from 60 krona to the dollar to 120. It was a horrible series of events for Iceland, but the collapse in the krona also led to surge in exports and tourism that kept unemployment contained.
Compare that to Ireland, which had a banking collapse of its own, which metastasized into a fiscal crisis. It uses the euro, so its currency remained strong even as the Irish economy fell into a deep downturn. In Iceland, unemployment peaked at 8 percent and has been falling since then. In Ireland, unemployment has been above 14 percent for three years and counting, with little evident sign of decline.
So that’s the case for dropping the euro: A free-floating currency can be a pressure valve for a troubled nation. Why would Cyprus not want to do it?
One of the many differences between Cyprus and Iceland is that Iceland faced no transition costs. It had its own currency, which fell on currency markets; it didn’t have to endure the transition away from a more widely used currency.
And those transition costs could be doozies. The current version of the bailout preserves deposits under 100,000 euros in Cypriot banks; if those euros were converted to a new Cypriot pound, they would surely plummet in value in anticipation of a run on the country’s currency. Everybody would suddenly be poorer.
It would simultaneously create a legal mess. Suppose you are a Cypriot company that owes a million euros to a business partner in Germany or Italy or Greece. Do you owe the debt in old euros now, or in new Cypriot pounds, worth some much smaller amount? Coming up with an answer may require years of litigation.
The geopolitical risks for Cyprus are even bigger. It has spent the last couple of decades integrating itself with Europe. It’s bigger than just the currency: As a member of the EU, its citizens can travel, work, and relocate freely to any of 27 countries from Finland to Portugal (the question of whether a country that dropped the euro could remain in the EU is an unsettled one). The rest of Europe has plenty to lose if Cyprus dropping the euro created new pressure on Greece, Spain, or other troubled companies to make a similar move; it could again strain the continent’s financial resources and its politics to keep one of the world’s two most important currencies from unraveling entirely.
In other words, for Cyprus there are no great options remaining. The real lesson of its dilemma: If you’re a small country (or a large one, for that matter), don’t let your banking system get so large that it could bring down your entire economy in the first place.