History lesson: the break-up of monetary unions25 June, 2012, 23:08. Posted by Zarathustra
Tags: Euro Crisis
Two years or more into the Euro crisis, we have all known by now that what the fatal flaws for the European monetary union is. It is a monetary union without fiscal and political union. The only way is for Europe to have a full fiscal union where financial stronger countries essentially transfer money to the weaker countries. That is of course not possible for Europe, because Europe is a place where people all speak different languages and all seem to dislike each other in one way or another.
And by now we also know that the European monetary union is hardly the first monetary union in history. Here we have mentioned briefly on the Latin monetary union, while others draw experiences of the break-up of the Soviet Union and the subsequent collapse of the Soviet rubble monetary union.
The following is the history lesson on monetary union, brought to you by Standard Chartered. In short, monetary unions are prone to break up.
The main takeaway is that logistical or legal barriers are never high enough to prevent a break up if the political will for the union is lost. Strong, rather than weak, countries end monetary unions. And political backing can be fatally undermined by long-standing structural and fiscal challenges. Warning signs of impending disintegration of a union include central bank policy ‘fragmentation’, while ‘IOUs’ to cover arrears in government payments can be the first step towards introducing a new currency. The banking system can play a pivotal role: a loss in confidence can accelerate the sequence of events, as well as trigger upheaval.
What makes monetary union survives? Politics, so it seems, that is not all about economics. Also, you might be surprised to learn that it isn’t the weakest countries that ultimately break the monetary union, rather, the stronger countries.
Under the Soviet Union (1922-1991), the rouble (RUB) was the common currency for the 15 Soviet republics until the breakup of the currency union in 1992-93, when the RUB was replaced by 13 different currencies outside Russia. The Czechoslovakian koruna was split into two separate currencies in 1993, after 74 years in existence. We pick out a few important lessons for euro-area leaders from these past breakups.
1. Continued political support is key for unions to survive
The breakup of the rouble (RUB) area following the demise of the Soviet Union and the currency breakup following the division of Czechoslovakia bring an interesting perspective to today‟s debate about the euro area. Both examples show the utmost importance of political backing behind the currency, and the alignment of political interests. In our view, political strains among the euro-area members pose the greatest threat to the survival of the euro (EUR). The current crisis has demonstrated ongoing shortcomings in leadership, governance and coordination. At the same time, grassroots support for the EUR is fading in some countries (for example, a majority of Germans want to return to the Deutsche Mark, according to recent opinion polls), anti-EUR political parties are gaining strength (though still firmly in a minority), and in the periphery there is growing resistance to the implementation of policies aimed at shoring up the single currency.
2. Strong, rather than weak, countries end monetary unions
Although the focus is on the weaker countries in the euro area and the risks that they pose to the current make-up of EMU, past experience shows that weak countries are often reluctant to leave currency/monetary unions and delay exiting, fearing that departure will lead to economic and political turmoil. In our three examples from history, it was the stronger countries or partners that brought unions to an end. The departure of the Baltics, and then Russia’s actions, ended the RUB bloc; in Czechoslovakia, mounting imbalances made the Czechs (the stronger partner) keen to accelerate a breakup; in the case of Argentina there wasn’t another country directly involved, but when the IMF (backed by the US) gave up, the game was over.
A related lesson is that fiscally-strong small countries can play a pivotal role. Pressures leading to the RUB break up intensified after the fiscally-strong Baltic countries left the area. Although some nationalist arguments were at play, economics played a major role as these countries saw belonging to the RUB currency area as a rising liability, while wanting to differentiate themselves from the weaker and fiscally profligate countries (which also happened to be in the south of the region).
3. Excessive central bank policy ‘fragmentation’ is a danger
Another key feature in the breakup of the RUB area was the chaotic decentralisation of monetary policy as coordination (and enforcement) of policy and credit creation at the central level failed. Monetary policy became anarchic in the run-up to the RUB breakup, particularly in Ukraine, where local money creation boomed, subsequently leading to hyperinflation (Ukraine introduced a parallel currency in 1992, which it printed heavily, further fuelling price growth). The distribution of seigniorage was also a particularly thorny issue, leading to increased tension between countries.
4. A currency breakup can be quick, and not necessarily chaotic
Czechoslovakia‟s example shows that a currency breakup can happen quickly – and smoothly, if it is properly planned; obviously there are many caveats to comparing Czechoslovakia in the 1990s and the euro area today. In particular, financial and banking markets were less developed in early 1990s Czechoslovakia, and koruna use was limited to a population of 16mn.