Breakup of ruble area lessons for euro
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Transcript of Breakup of ruble area lessons for euro
Free Slides fromEd Dolan’s Econ Blog
http://dolanecon.blogspot.com/
The Breakup of the Ruble Area (1991-1993):
Lessons for the Euro Post prepared July 3, 2010
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Could the Euro Area Break Up?
Debt crises in Greece, Spain, and other EU members have raised the question— could the euro area break up?
If so, who would leave first? Economically weak members like Greece? Or stronger members like Germany?
These slides look at the breakup of an earlier currency area—the short-lived ruble area of 1991-1993—and draw some lessons for the euro
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Collapse of the Soviet Union and Emergence of the Ruble Area
The Soviet Union was disolved in December 1991
Each of its 15 former member republics* became independent
Initially, all 15 shared the Soviet ruble as their currency, forming a common currency area superficially similar to the 17-nation euro area
The former branches of the USSR State Bank (Gosbank) became the central banks of the newly independent states
*The Baltic countries, Estonia, Latvia, and Lithuania, had declared independence earlier, in the summer of 1991
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Inflation in the Ruble Area
Unlike the euro area, the ruble area suffered serious inflation from its birth
Inflation in the ruble area arose from three major problems:1. The legacy of perestroika
2. Monetization of budget deficits
3. Design flaws leading to a free rider problem
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Problem 1: The Legacy of Perestroika
Perestroika was Mikhail Gorbachev’s failed attempt to reform the Soviet economy in the late 1980s
Rapid growth of money and credit inflated demand, but reforms failed to increase supply of goods
Administrative price controls plus excess demand led to shortages and long lines in stores
When price controls were removed in January 1992, repressed inflation was released and prices jumped upward
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Problem 2: Monetization of Budget Deficits
Weak, corrupt tax systems and other factors led to large budget deficits
There were no working markets where the deficits could be financed by selling bonds to the public
Governments had little choice but to finance deficits with credits from their central banks, a process that added to the monetary base, the money stock, and inflation
This practice is known as monetization of budget deficits
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Problem 3: Design Flaws and Free Riders
Within the ruble area, the Bank of Russia had a monopoly on printing paper currency
However, all 15 central banks could create bank credit, causing growth of the money stock
This gave rise to a free rider problem: Each country could use central bank
credit to finance its budget deficit The resulting inflation was transmitted
among all 15 member countries Each country had an incentive to act as
a free rider, enjoying the benefits of credit expansion while shifting the inflationary costs to its neighbors
This chart shows that Ukraine was especially active in creating ruble area money in 1992. After mid-1993, opportunities to play the free rider largely disappeared
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To stay or to leave?
Reasons to stay . . . The ruble might help maintain trade ties
with Russia and other neighbors Your country might not be ready to
administer its own currency successfully You might want to exploit free rider
opportunities to finance your deficit
Reasons to leave . . . Since Russia was not doing a good job
of managing the ruble, you might want to take control of your own currency to fight inflation
You might want to shift trade away from Russia and other former Soviet states
You might want your own currency as a symbol of your newly-gained independence
As of mid-1992, the pros and cons of staying in the ruble area looked like this . . .
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The Demise of the Ruble Area
Starting in mid-1992, countries left the ruble area one by one
The Baltic states went first Stronger institutions Wanted to stop inflation Wanted to redirect trade westward Strong nationalistic motivation
In July 1993 Russia replaced the old Soviet ruble with a new Russian ruble, making the ruble area less attractive to others
Tajikistan, torn by civil war, was the last to leave, in May 1995
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Ruble vs. Euro: Monetary Free Riders and Safeguards
Monetary free riders in the ruble area . . .
The Bank of Russia, as the leading central bank of the ruble area, maintained a monopoly only on issue of paper currency
Other central banks could freely create bank credit
Member countries could act as free riders by financing excessive budget deficits with bank credit, while shifting part of the inflationary consequences to their neighbors
Free rider problem was one of the factors that brought down the ruble area
Safeguards in the euro area . . . European Central Bank maintains
complete control over both paper currency and credit conditions
Central banks of euro countries act only as agents of the ECB, cannot act as free riders in money creation
Some concerns remain about opportunities to seek national advantage in the area of bank regulation, where member countries have more authority
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Fiscal Fee Riders and Safeguards in the Euro Area
Fiscal free riders in the euro area Euro area governments retain principal
authority over fiscal policy A country that runs excessive budget
deficits gains all the political advantages from high spending and low taxes, but shifts part of burden to other euro countries If ECB needs to raise interest rates to
offset excessively expansionary fiscal policy, it must do so for all members
Unsustainable deficits by one country may undermine confidence in stability of the euro area as a whole and worsen borrowing conditions for all members
Safeguards are not adequate. . . EU rules limit deficits to 3% of GDP and
debt to 60% of GDP, but it has proved impossible to enforce these rules
Euro zone rules contain a strict “no bail out” clause, but this rule has been weakened by the 2010 rescue package for Greece and other high-deficit countries
In the past, the ECB did not purchase bonds of individual member countries, but in 2010 it began to do so under pressure of the Greek crisis
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Why Some Countries Might Want to Leave the Euro
A number of euro area countries have excessive debt and/or deficits. Their international competitiveness is poor, and they might gain by devaluation if they left the euro
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Why Weak Economies Would Find it Hard to Leave the Euro
Under current conditions, weak economies would find it hard to leave the euro in order to devalue
Devaluation would cause inflation Devaluation would make it harder to pay
public and private debts and could trigger a default
After default, it might be hard to reenter world financial markets
As people came to expect exit, there could be a run on banks as residents shifted deposits to banks in other euro-area countries
For a good short discussion of the exit problem, see Barry Eichengreen, “The Euro: Love it or Leave it?” http://voxeu.org/index.php?q=node/729
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Why Strong Economies Found it Easy to Leave the Ruble
Relatively strong countries like the Baltics left the ruble area early and quickly brought inflation under control
Independent currencies helped stabilize local financial systems
Stabilization made it easier, not harder, for countries leaving the ruble to attract foreign finance for public and private debts
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Lessons for the Euro from the Ruble Experience
Lesson 1: Beware the free rider problem . . .
Free riders can undermine a currency area when they have an incentive to put national interests above the interests of the currency area as a whole
The nature of the free rider problem—monetary vs. fiscal—was different in the ruble area from that in the euro area, but the problem is real in both cases
Lesson 2: Exit barriers are not symmetric
It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs
These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area
A hypothetical scenario for breakup of the euro area: A coalition of high-debt countries captures control of the ECB. They try using inflation to ease their debt burdens and stimulate their economies. At that point, strong, low-inflation economies like Germany could be tempted to leave the euro and could do so without risk of default, inflation, or bank runs.