One day, the legislature in the state where you live passes a new law: Until further notice, you're not allowed to take your money to another state.
There are exceptions. You can take a few thousand dollars with you if you go on a trip. You can do some out-of-state shopping on your credit card, but not too much. Beyond that, all your money — your checking account, your savings account, the cash you buried in your backyard — has to stay in your state. You're free to leave the state, as long as you don't take your money with you.
That's what it's like today for people who live in Cyprus.
Cyprus is having a financial crisis right now. One of the country's biggest banks failed and is about to be shut down; all of the banks there have been closed for a week and a half. The Cypriot government is trying to figure out how to reopen the banks without triggering a massive bank run.
As part of the solution, the government is imposing what are known as capital controls: rules that limit how much money people can take out of the country.
Capital controls have a long and surprisingly interesting history. They were common for a long time; then they went out of fashion; now people like them again, sometimes. (For more on this, see Paul Krugman's recent column on the subject, which had the excellent headline Hot Money Blues.)
But the case of Cyprus isn't just any set of capital controls: It's a set of capital controls within a currency union. Or, I should say: It's a set of capital controls within a currency union!
The whole point of a currency union — the reason every U.S. state uses dollars and all the countries in the eurozone use the euro — is that the currency is the same everywhere it's used.
Capital controls break this fundamental rule. To see why this is so, ask yourself which of the following you would rather have:
- A bank account in Cyprus with 20,000 euros in it. You are free to spend this money any way you want, as long as you want to spend it in Cyprus.
- A bank account with 20,000 euros in it in any other country that uses the euro. You are free to spend this money anywhere in the eurozone — or to exchange it for dollars or any other foreign currency and spend it anywhere in the world.
In other words, a euro in the bank in Cyprus is less valuable than a euro in the bank anywhere else in the eurozone. Tyler Cowen described this as "Cyprus leaving the euro but keeping the word 'euro' to save face."
Capital controls are clearly bad news if you have a bunch of money in a bank account in Cyprus. But the controls are also a warning to people in much bigger eurozone countries: A euro in your country may someday be worth less than a euro in the rest of Europe.