Breakup of the Ruble Area: Lessons for the Euro

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The Breakup of the Ruble Area (1991-1993):

Lessons for the EuroUpdated June, 2013

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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

June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/


Collapse of the Soviet Union and Emergence of the Ruble Area

The Soviet Union was dissolved 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



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



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



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



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



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 . . .



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



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

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 (with some minor technical exceptions)

However, there are still many unresolved problems about bank regulation and resolution of failed banks in the euro area



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 seems to have become a dead letter after bailout packages for Greece, Ireland, Portugal, and Cyprus

In the past, the ECB did not purchase bonds of individual member countries, but it has now begun to do so under pressure of the Greek crisis



Why Some Countries Might Want to Leave the Euro

Economic performance of eurozone countries has been very uneven in many respects

For example, this chart shows that some countries, notably Germany, have increased their share of world exports since the introduction of the euro while others have decreased their share

Some economists have suggested that by leaving the euro and devaluing, lagging countries could improve their export performance and thereby boost employment and economic growth


Why Weak Economies Would Find it Hard to Leave the Euro

However, 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

Posted July 3, 2010 (revised Jan. 31, 2011) Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why Strong Economies Might Find it Easier to Leave

By comparison, when the ruble area broke up, relatively strong countries like the Baltic states were the first to leave

They 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

For the same reasons, stronger economies like Germany could find it easier to leave the euro than weak ones


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


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Breakup of the Ruble Area: Lessons for the Euro

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