Unintended Consequence of Cyprus “Rescue”

Written by Hilary Barnes

It wasn’t intended to happen this way, but one of the side effects of the Cyprus crisis and the troika’s botched rescue plans is that Cyprus will from now on be subject to severe controls on capital movements. This means that Cyprus is in a situation which makes leaving the euro possible.

Kevin O’Rourke at the Irish Economy blog draws attention to a 2010 article by Barry Eichengreen, who pointed out that any serious discussion of a euro exit in any country would provoke a bank run; the ECB would probably refuse, given the circumstances, to act as lender of last resort; it would be the mother of all financial crises. Therefore the discussion would stop.

But that is not the case once you have capital controls in place. And so we have Paul Krugman in his New York Times blog, arguing that, yes, now is the time for Cyprus to leave the euro.

So here it is: yes, Cyprus should leave the euro. Now the reason is straightforward: staying in the euro means an incredibly severe depression, which will last for many years while Cyprus tries to build a new export sector. Leaving the euro, and letting the new currency fall sharply, would greatly accelerate that rebuilding. If you look at Cyprus’s trade profile, you see just how much damage the country is about to sustain. This is a highly open economy with just two major exports, banking services and tourism – and one of them just disappeared. This would lead to a severe slump on its own. On top of that, the troika is demanding major new austerity, even though the country supposedly has rough primary (non-interest) budget balance. I wouldn’t be surprised to see a 20 percent fall in real GDP.

Another discussion is taking place: is the Cyprus euro in fact already worth less than other euros? Don’t think this can be true. If you have Cyprus euro notes and coins in your pocket, they will be accepted for payment in Paris, Berlin and Madrid and so on.

Cyprus euros will remain at the same value as other euros until there is (if there is) an orderly switch of euros into new Cyprus pounds at the rate of 1:1, but the Cyprus pound would probably only buy perhaps 40 to 60 euro cents (pure guess).