All the notes were "dollars" (which is less of a clue than you might think, but yes, you are correct about the country to which I am referring), but if you took your dollar notes from, say, a Suffolk bank and tried to cash them at a New York bank (or deposit them), you would not necessarily get the face value of the note. The bank you went to would open up a recent newspaper and look at a chart to figure out how much to discount your notes.
Needless to say, this was a bank without deposit insurance. If you went to a bank with notes written by that bank and asked for specie, you might be able to get the amount you asked for ... and you might not. If you didn't, and they told you you could get only 10% of what you were asking for, then you might go tell all your business buddies and they'd all show up to get what they could before everyone else found out. Bank run. If the bank had to put up a sign saying, sorry, no money left, come back later, maybe (I blogged about the unthinkable proposal to do exactly that at the BofE recently), it could turn into a more general run on other, unrelated banks (because in the country I am describing, branch banking was severely limited -- that, right there, I've _really_ told you which country this is). Which would lead to a general stoppage of business, a Panic, followed by a Depression and Deflation, general distrust of paper currency thus the noose that was hard money would be wrapped around the neck of the economy in general, at least until the next big discovery of gold (because silver, while used a lot, was still met by significant ambivalence and wasn't fungible across national borders).
This was a country, and a time, when people lost their jobs, their homes, their farms, their ability to feed themselves and their families, when their (local) bank went under. You didn't even have to lose any of _your_ money when this happened: the local fat cats would become lean and that would affect you because they would idle businesses, deflation would occur, etc. And banks went under whenever one of these things happened because no matter how careful you were, you had to loan your deposits out and when everything went south, you went down, too. Also, some banks were total fucking scams (cf. Joseph Smith, the Mormons, etc.).
How come this stopped happening, for so long that we sort of don't really remember what that was like? Well, we changed a lot of the rules of the game. After two rounds of attempts at a central bank, we wound up with a system of reserve banks for banks to deposit their reserves in (banks for banks), and a bunch of regulations requiring them to _have_ reserves. That helped, and it also helped that the system would discount (accept!) notes when no one else would (lender of last resort). And over time, efforts have been made to improve the quality of lending and reduce the fraud and so forth. It's been remarkably effective.
One of the most important steps in this process was to sever the connection between paper notes and "hard money". It was important to do this, because there isn't as much hard money as there needs to be to handle the size of our economy (except when there's too much). For a long time people believed that this was, in the long run, "good" because it ensured that debt to be paid a long time in the future could not be inflated away, redistributing money from those who had it to those who had only borrowed it. Fortunately, we've mostly gotten smarter about this. Mostly.
However, we still do get into trouble with not-so-great lending. It's especially bad when the people who are supposed to _stop_ not-so-great lending instead decide to encourage it (that's what our last boom was). When a bank is forced to mark down its bad loans, it is saying it doesn't have as much money to give to depositors when they ask for it.
If the bank has borrowed money by issuing bonds, or if the bank has many equity holders (people who own stock in it), then you can get the money to give to the depositors by telling the bond holders and the equity holders that they just aren't going to get their money back. Ever. If you watch how the FDIC winds down banks having difficulties in the current United States, this is pretty familiar. But the bank(s) in Cyprus don't have a lot of bond holders or equity holders. Just depositors. You can make things right for the banks in Cyprus in one of two ways: ask the nice people in the Eurozone (and elsewhere) see what they're willing to give Cyprus so Cyprus can give people "their" money back (that is, take money from a German taxpayer's bank account -- through taxation -- to give to a Cypriot so they don't lose the money they had in the bank) or you can ask the Cypriot bank depositor to accept a smaller amount back than they originally deposited.
And this, fundamentally, is why I feel so enamored of Dijsselbloem, and why I feel so mad every time I read coverage of the banking problems that he and his team have largely addressed. Once upon a time, we _too_ had a shared currency that no one controlled. And our version of Germany wasn't nearly as nice about things as the Eurozone. And JP Morgan was nothing like as good a negotiator as Dijsselbloem.
Here's what set me off today:
"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."
And what should you do about that? Well, make sure your elected officials don't piss off the people who will be helping you out when you get into trouble, for starters.
Also, capital controls should make everyone _really really happy_ because they are way less bad than the alternatives.