Sorry about the one-day interruption in service — I forgot to mention that it was a travel day, and as it turned out I was too tired on arrival to blog or actually do anything.
And with that, back to Cyprus.
Kevin O’Rourke asks a good question. He points out that the classic argument for the euro’s irreversibility, from Barry Eichengreen, was that any threat to leave the euro would set off “the mother of all financial crises”: a crisis of confidence that would collapse a country’s banks. I used to believe this, but eventually noticed that the logic would break down if a country had its banking crisis first, and was forced into an Argentine-style corralito.
And Cyprus is there: closed banks, capital controls. In an important sense it’s already off the euro; it has an inconvertible currency, the Cypriot euro, that just happens to be pegged to the other euro at a parity of 1. Why, exactly, should this parity be sacrosanct?
Wait, there’s more. The theory of optimum currency areas says, in brief, that countries face a tradeoff between convenience and adjustment. Having your own currency raises transaction costs and makes business more difficult; but giving up your own currency means that you have to adjust to overvaluation through deflation, which is much more costly than devaluation. At this point, however, Cyprus has made doing business very difficult via capital controls, while retaining its inability to deal with overvaluation via currency realignment. So it has created a pessimal currency area, offering the worst of both worlds.
And Cyprus is now very overvalued — not only have the big capital inflows of yore dried up, a major export industry — offshore banking — has just died.
OK, there are still some considerations: access to ECB lending, possibly anti-inflation credibility, and general relations with the European Union. But Cyprus is now almost surely facing the prospect, not of recession, but of deep depression. Is this worth it?