Countries often impose extreme “temporary” policies in emergencies. In Britain, emergency rent controls, passed in 1917, were not substantially amended until 1988. In the Second World War, emergency exchange controls were imposed and left in place until 1979. Cyprus is now facing its own emergency, as its banking system collapses. But we should be extremely wary of so-called temporary measures, like controls on the movement of capital, designed to ease the crisis.

The EU’s Treaty of Rome is very clear. Article three demands the “abolition… of obstacles to freedom of movement of persons, services and capital”. In fact, this aspiration did not become a reality until the 1990s. Although explicit controls on the movement of capital were abolished quite early in most cases, many countries regulated pension fund and insurance company investment in ways that prevented free movement. However, it is the explicit controls that are draconian.

Capital controls restrict freedom of movement. Individuals have to go through bureaucratic processes to go on holiday and take currency with them. I had South African friends who had problems in the late 1980s when they wanted to emigrate to the UK, but could not bring their savings. Capital controls control people.

They also come with a cost. If Cypriots cannot invest in other countries, they cannot diversify their portfolios or seek higher returns. Diversification is a vital risk management tool and the smaller an economy, the more important diversification is. Indeed, a country running an offshore banking centre, as Cyprus is, simply cannot operate with capital controls – or with the threat of them.

Many of us expected that the creation of the euro would undermine free movement of capital within the EU. The inflationary excesses and investment booms that were bound to arise in some countries, as a single monetary policy was implemented in a diverse economic area, were always likely to create problems that politicians would seek to overcome using exchange controls. But an inflationary boom requires either a deflation correction or an exchange rate adjustment (which is impossible in the Eurozone). Preventing capital from leaving the country will only delay adjustment and prevent its financial sector from restructuring.

Huge numbers of bad loans have been made by Cyprus, including to the Greek government. Bad debts should be recognised and investors should take the consequences so that an orderly restructuring and winding-up of banks can be undertaken. The rest of the Eurozone should not get involved in this process. A case can be made for temporary controls on bank withdrawals to stabilise the situation while haircuts on deposits are made and legal restructuring is undertaken. But these controls must expire after a few weeks. The only role the EU should play is to expel Cyprus from the euro – and ultimately the EU – if it maintains capital controls beyond the end of May.

Philip Booth is editorial and programmes director at the Institute of Economic Affairs, and professor of risk management at Cass Business School.

Read the original City AM article here.