In a sign it was at least preparing for the worst, the Cypriot government sought powers on Thursday to impose capital controls to stem a flood of funds leaving the island if there is no deal before banks reopen following this week's shutdown.
Parliament will reconvene later on Friday to debate a raft of government crisis measures after lawmakers adjourned a late-Thursday sitting saying they needed more time for consultation.
Even those measures looked likely to fall short of a promised "Plan B" to raise the 5.8 billion euros demanded by the EU in return for a 10 billion euro lifeline from the EU and IMF.
The European Central Bank said it would cut off liquidity to Cypriot banks without a deal, and a senior EU official told Reuters the bloc was ready to see the island banished from the euro to contain damage to the wider European economy.
The problem is confidence. If Cyprus burns, then the current PIIGS on the barbecue spit, Portugal, Ireland, Italy, Greece, and Spain, are looking like they'll be next. Paul Krugman sums it up:
What can be done? First off, Cypriot banks cannot honor their debts, which unfortunately overwhelmingly take the form of deposits. So a default on deposits is inevitable.
As I now understand it, the initial screwup was a joint error of the Europeans and the Cypriots. Europe didn’t want an explicit bank resolution, which would among other things have given clear seniority to small insured deposits; instead, it wanted this essentially fictitious tax scheme. Meanwhile, the Cypriot government still has the illusion that its banking model can survive, and wanted to limit the hit to the big overseas depositors. Hence the debacle of the small-deposit tax.
In the end this probably comes, in some version, to what it should have been from the start — a big haircut on deposits over 100,000.
That's going to A) piss off the Russians and B) turn into a truly ugly week in Europe starting Monday, regardless of what happens now. But with TV screens across Europe soon to be filling with bank runs and riots, I'm betting more than a few people start getting really nervous and moving their money out of other banks in Europe too. That could get really nasty and quickly.
We'll see. So far the ECB has been able to stomp out the fires when they pop up, but each round gets more and more costly. If Cyprus is the bridge too far, then hold on to your seats.