Hugo Dixon

Cyprus is no longer centre stage. Nicosia has agreed a 10 billion euro bailout deal with its euro zone partners and the International Monetary Fund. A visible bank run has been averted by stringent capital controls. International markets, which only ever suffered a mild bout of jitters, have calmed down.

But it would be foolish to forget about Cyprus. The small Mediterranean island is edging towards euro exit. Quitting the single currency would devastate wealth, fuel inflation, lead to default and leave Cyprus friendless in a troubled neighbourhood. Even so, the longer capital controls continue, the louder the voices calling for bringing back the Cyprus pound will grow.

President Nicos Anastasiades is against Cyprus leaving the euro. But the main opposition communist party wants to pull out. A smaller opposition group wants to stay in the euro but kick out the troika – the European Commission, the European Central Bank and the IMF. The country’s influential archbishop is also critical of the troika.

Anastasiades can hold the line for now. After all, he has just been elected and the constitution gives him huge power. What’s more, there are strong arguments for staying inside the single currency – not least the fact that, otherwise, it would lose the 10 billion euros (or nearly 60 percent of GDP) of bailout money.

If Nicosia brought back the Cyprus pound, it would plummet in value. Nobody knows how much, but economists guess it might be up to 50 percent. Cypriots are complaining at the massive haircuts suffered by big depositors in their two largest banks: Bank of Cyprus and Laiki. Such a massive devaluation would savage the wealth of all other depositors.

The Cypriot catastrophe shows just how far away the euro zone is from creating its much-touted “banking union”. There was no euro zone supervision of Cyprus’ big banks, no transnational approach to put them into controlled bankruptcy, no common deposit insurance and no flow of bank rescue funds from abroad.

Instead, there was weak supervision by the Central Bank of Cyprus and a mad scramble to carve up the banks’ assets on national lines. Nicosia was left to shoulder the whole cost of protecting small depositors and the euro zone said that none of its bailout cash could be injected into the troubled banks.

Optimists hope the fiasco will provide the euro zone with the impetus to complete its banking union. But it is equally possible that core countries such as Germany, Finland and the Netherlands will become even more reluctant to absorb the liabilities of bust peripheral banks.

Cyprus’ capital controls are an “omnishambles”. If the Argentine-style “corralito” really can be lifted in seven days, the damage could be contained. But that doesn’t seem credible. Extended controls could spawn bribery, sap confidence, further crush the economy, spread contagion and ultimately lead to the country’s exit from the euro.

The lesson of capital controls elsewhere is that, once they are imposed, they are hard to remove. Iceland’s curbs are still in place five years after they started. In Argentina, they lasted a year.

There’s little reason to suppose it will be much different in Nicosia. After all, the restrictions – which limit both the amount of money people can take from their banks and the amount they can transfer abroad – have been imposed because the lenders do not have enough access to ready funds. If there’s not sufficient liquidity today, why should anybody believe there will be enough in a week, a month or even a year?

Imposing capital controls would be a historic mistake for Cyprus and the euro zone – even worse than the crass idea of taxing uninsured deposits. Non-cash transactions would be limited, while withdrawals from cash machines would be rationed.

This would be equivalent to Argentina’s “corralito”, which lasted a year in 2001/2002. If capital controls are imposed, it will be almost impossible to lift them because people will stampede for the exits once they are removed. But such heavy-handed rationing of limited cash would clobber an economy which is already heading for a slump.

Some people will say that Cyprus has already endured a week of capital controls because of the extended bank holiday since last weekend’s botched bailout. But officially imposed indefinite capital controls – blessed by the euro zone and the International Monetary Fund – would be far worse.

Cyprus will pay dearly for its sins. The Mediterranean island has committed many follies over the years – and is still making mistakes.

The Cypriots seem congenitally inclined to overestimate their negotiating position. In recent years, their first big folly was to reject in 2004 the United Nations plan for uniting their island. That irritated their European Union partners, meant that Cyprus still has a weak strategic position vis-à-vis Turkey and leaves a jagged scar across the island.

The last Communist government was also criminal in its failure to act as the crisis in Greece threatened to swamp Cyprus. If it had been willing to restructure the banks, the Cypriot economy would now be in a lot better shape. It was also much easier to do a deal with Germany then than now, when Angela Merkel is only months away from an election.

David Cameron is planning a keynote speech on Britain’s relationship with the EU later this month. Here is what the UK prime minister should say.
 
 The euro crisis is forcing euro zone nations to rethink how they wish to run their currency union. It is also forcing European Union countries that don’t use the single currency, such as Britain, to rethink their relationship with Europe.

We have three main options: quit the EU; move to the edge as the euro zone pushes towards closer union; and seek to stay at the heart of Europe and influence its development in a way that promotes our interests.

There are members of my own Conservative party who would like Britain to quit. There are others who would like us to move to the periphery. But I am determined to make sure that we stay at the centre.

The euro crisis is to a great extent a confidence crisis. Sure, there are big underlying problems such as excessive debt and lack of competitiveness in the peripheral economies. But these can be addressed and, to some extent, this is happening already. Meanwhile, a quick fix for the confidence crisis is needed.

The harsh medicine of reform is required but is undermining confidence on multiple levels. Businesses, bankers, ordinary citizens and politicians are losing faith in both the immediate economic future and the whole single-currency project. That is creating interconnected vicious spirals.

The twin epicentres of the crisis are Spain and Italy. The boost they received from last month’s euro zone summit has been more than wiped out. Spanish 10-year bond yields equalled their euro-era record of 7.3 percent on July 20; Italy’s had also rebounded to a slightly less terrifying but still worrying 6.2 percent.

The euro zone crisis is a multi-dimensional game of chicken. There isn’t just a standoff between the zone’s core and its periphery; there is also one between the European Central Bank and the euro zone governments over who should rescue the single currency. In such games somebody usually blinks. But if nobody does, the consequences will be terrible.

The brinkmanship between the governments is over how much help the northerners, led by Germany, should give the southerners. The core is effectively threatening the peripheral countries with bankruptcy if they don’t cut their deficits and reform their economies. The periphery is saying that, if they collapse, so will the entire single currency which has been so beneficial to Germany’s economy. The game is being played out transparently in Greece and covertly in Spain.

But even if the core eventually decides to help the periphery, there is a struggle of whether the aid should come from governments or from the ECB. Politicians would like the central bank to do the heavy lifting to avoid having to confront taxpayers with an explicit bill. But the ECB doesn’t think it is its job to help governments, arguing that such support violates the Maastricht Treaty.

Greece needs to go to the brink. Only then will the people back a government that can pursue the tough programme needed to turn the country around. To get to that point, bailout cash for both the government and the banks probably has to be turned off.

It might be thought that the country is already on the edge of the abyss. This month’s election savaged the two traditional ruling parties which were backing the bailout plan that is keeping the country afloat. Extremists of both right and left gained strength – voters liked their opposition to the plan. But nobody could form a government. Hence, there will be a second election on June 17.

Will this second election express the Greeks’ desire clearly: stick with the programme and stay in the euro; or tear up the plan and bring back the drachma? That is how Greece’s financial backers in the rest of the euro zone, such as Germany, are trying to frame the debate. But the electorate doesn’t yet see the choice as that stark. Roughly three quarters want to stay with the euro but two thirds don’t want the reform-plus-austerity programme.

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises – it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.