Tale of Two Euros

The past two weeks of the Cyprus banking crisis have been chaotic at the least, and challenging known economic theory at the worst.  The most recent developments, in my opinion, may be creating the biggest risk the unified currency has faced at any point in this crisis.

The first steps involving “resolving” the banks are exactly as they should be:  Burn up the stockholders, then the bondholders, then the uninsured depositors.  Moral hazard is removed from the equation and risk is compensated in the accepted hierarchy.

The next step, however, is the source of my concern.  That step involves implementing capital controls.

Implementing capital controls is neither a new nor unilaterally negative phenomenon.  Their use has ebbed and flowed throughout history.  They were prevalent during World War I, eased in the years leading up to the rise of the Nazi party, and returned in forms such as the tax imposed by the Nazis on the Jews attempting to leave Germany to avoid oppression.

During John Maynard Keyne’s heyday (the Bretton Woods era), capital controls were widely implemented and were considered a lynchpin in controlling the breakouts of banking crises.  The history of that era would certainly validate that correlation (although not necessarily proving causation).

August 15, 1971 marked the end of Bretton Woods when Nixon abolished the gold standard.  From that point until the most recent financial crisis, capital controls were largely eliminated – first in the developed countries and later in the emerging markets.  Lack of capital controls accelerated globalization while, at the same time, increasing the likelihood of banking crises.

Then came the 2008 financial crisis and the Great Recession.  Suddenly countries pined for the good old days of Bretton Woods – or at least the financial stability capital controls brought to that era.  Keynesian economic policies began being implemented across the West with bond-buying programs and the manufacturing of money being the perceived saviors from the crisis.  Perhaps it was a natural progression, then, that Keyne’s other belief – the usefulness of capital controls – would surface at this time.

Which leads me to my confusion about the controls about to be implemented in Cyprus.

Capital controls don’t exist in a vacuum.  In fact, one model of capital controls involves the idea of the “Impossible Trinity.”  Basically, the Impossible Trinity says that countries desire three fortuitous things:

  • Free capital flows (no capital controls)
  • A fixed exchange rate
  • Sovereignty over monetary policy

The rub, however, is obtaining all three is an impossible trinity.  A country can only have two at the expense of the third.  Graphically, it works like this:


A = Free capital flow and fixed exchange rates; therefore, there will be no sovereignty in monetary policy

B = Free capital flow and sovereignty in monetary policy; therefore, there can be no fixed exchange rate

C = Fixed exchange rate and sovereignty in monetary policy; therefore there will be no free capital flows

Flipping the formula for “C” over, implementing capital controls leaves you with two desirable levers:  Fixing your exchange rate and implementing monetary policy as a sovereign.  Unfortunately for Cyprus, neither of those two desirable levers is at their disposal as part of a unified currency.

I think that puts Cyprus in uncharted territory.  In a way, having no levers puts Cyprus at the full mercy of the decisions made by the monetary union as a whole.  The union has free capital flow (for now) providing it with flexibility in exchange rates and monetary policy.  Cyprus, on the other hand, is now singly focused on stemming the exodus of cash when its banks reopen.  But that cash is denominated in Euros.

By restricting the mobility of Cyprus Euros, do you not create a second class of Euros – those that are mobile and those that are restricted?  And shouldn’t the restricted class of Euro’s be worth less than those maintaining their mobility?  And since Cyprus has no fortuitous levers at its disposal to find equilibrium, won’t this imbalance persist?  And, by the way, doesn’t whole idea violate the European treaty forbidding the use of capital controls by any country within the monetary union?

To me, this is a troubling crack in the facade; both from monetary and a legal perspectives.  History may look back at these “Hail Mary” attempts to save the common currency as the very seeds of its demise.