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Breakup of ruble area lessons for euro

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Ed Dolan
Ed Dolan

The document summarizes lessons from the breakup of the 1991-1993 ruble currency area that may apply to the euro currency area. It discusses how the ruble area suffered from monetary free riders as central banks could expand credit, fueling inflation. Weaker economies found it hard to exit due to risks of default and bank runs. Stronger economies like the Baltics more easily left the ruble to curb inflation and attract foreign finance. Two lessons are that free riders can undermine currency areas and exit barriers are not symmetric, favoring strong economies.

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Free Slides from Ed 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 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ *The Baltic countries, Estonia, Latvia, and Lithuania, had declared independence earlier, in the summer of 1991
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: The legacy of perestroika Monetization of budget deficits Design flaws leading to a free rider problem Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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 . . .
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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.

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Breakup of ruble area lessons for euro

  • 1. Free Slides from Ed 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 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
  • 2. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 3. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ *The Baltic countries, Estonia, Latvia, and Lithuania, had declared independence earlier, in the summer of 1991
  • 4. 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: The legacy of perestroika Monetization of budget deficits Design flaws leading to a free rider problem Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 5. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 6. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 7. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
  • 8. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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 . . .
  • 9. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 10. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
  • 11. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
  • 12. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 13. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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
  • 14. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 15. 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 Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ 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.