In Cyprus rescue, EU steps on a basic freedom

In allowing Cyprus to impose capital controls, the EU violates one of its founding principles – the free flow of money (and goods) to help unite nations.

The Monitor's View

 For more than six decades, the world has admired Europe as it shed past tendencies for war by binding many nations into a pact based on the free flow of money, people, and goods. A common market, even a common currency, has indeed curbed aggressive nationalism.

This grand experiment, however, has just violated one of its core principles. The latest financial rescue by the European Union of a member, Cyprus, includes a curb on the free flow of money into and from the island. This step would be similar to a rescue of Detroit by Washington that requires residents not to take dollars outside city limits or to bring any in. The effect would be to have two, walled-off currencies.

By going along with capital controls to help keep Cyprus in the eurozone, both the EU and the International Monetary Fund (IMF) send a signal to other troubled economies in Europe that their citizens may not be able to trust that their money can be freely transferred to the most productive investments within the 17-nation eurozone. Yet such a basic freedom is the cornerstone for market discipline, economic efficiency, competitive innovation – and Europe’s future as a model for ensuring peace.

Capital controls are a blunt instrument for any government to use. They are most often employed because of bad economic policy, such as in Argentina, or when a country tries to control many aspects of its economy, such as in China. Small nations with weak financial systems try to curb money flows to prevent bubbles in certain markets – or prevent a market collapse if investors flee. But the result of such curbs hurts their economies in the long run.

The EU knows it stepped over a line with the Cyprus rescue package (which includes a hefty tax on large-scale depositors in Cypriot banks).

“Measures to restrict or limit free movement of capital can only be temporary,” said Michel Barnier, the European commissioner for the EU’s single market. There is even some question whether EU law has been broken.

And in a March 5 speech, the US Treasury’s undersecretary for international affairs, Lael Brainard, warned that capital controls in emerging economies “intensify the risk of inflation and asset bubbles.”

“With global growth weak,” she said, “it’s vitally important that the growth strategies in the world’s largest economies be mutually compatible.”

In December, the IMF abandoned decades of advice to developing nations about avoiding capital controls and adopted a new policy. It now sees targeted and temporary controls as essential for financial stability in specific cases. Many economists, however, disagree, citing studies on how restrictions on money flows hurt local firms that rely on foreign credit. Most of all, investor confidence in a country is difficult to restore.

The IMF should rather insist that countries build up currency reserves to fight off financial speculators, reduce the size of banks, and strengthen their financial markets to make them globally competitive. In the case of Cyprus, its big mistakes were allowing one or two banks to dominate the economy and relying on “hot money” from Russian oligarchs.

When Cypriot banks reopen as expected this week after being closed during the rescue talks, the capital controls may do little to restore confidence in the island’s economy. They are expediency at the expense of principle.

Germany and other healthy EU economies, while weary from the expense of multiple rescues, could have avoided this path by providing liquidity to Cyprus banks, as was done for the banks of Spain and Ireland. And they should have insisted on bank reform before even admitting Cyprus into the EU.

Europe’s experiment in free markets as a tool for peace needs to get back on track quickly.