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? <ul><li>Debt crises in Greece, Spain, and other EU members have raised the question— could the euro area break up? </li></ul><ul><li>If so, who would leave first? Economically weak members like Greece? Or stronger members like Germany? </li></ul><ul><li>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 </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Collapse of the Soviet Union
and Emergence of the Ruble Area <ul><li>The Soviet Union was disolved in December 1991 </li></ul><ul><li>Each of its 15 former member republics* became independent </li></ul><ul><li>Initially, all 15 shared the Soviet ruble as their currency, forming a common currency area superficially similar to the 17-nation euro area </li></ul><ul><li>The former branches of the USSR State Bank (Gosbank) became the central banks of the newly independent states </li></ul>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
<ul><li>Unlike the euro area, the ruble area suffered serious inflation from its birth </li></ul><ul><li>Inflation in the ruble area arose from three major problems: </li></ul><ul><ul><li>The legacy of perestroika </li></ul></ul><ul><ul><li>Monetization of budget deficits </li></ul></ul><ul><ul><li>Design flaws leading to a free rider problem </li></ul></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 1: The Legacy of
Perestroika <ul><li>Perestroika was Mikhail Gorbachev’s failed attempt to reform the Soviet economy in the late 1980s </li></ul><ul><li>Rapid growth of money and credit inflated demand, but reforms failed to increase supply of goods </li></ul><ul><li>Administrative price controls plus excess demand led to shortages and long lines in stores </li></ul><ul><li>When price controls were removed in January 1992, repressed inflation was released and prices jumped upward </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 2: Monetization of Budget
Deficits <ul><li>Weak, corrupt tax systems and other factors led to large budget deficits </li></ul><ul><li>There were no working markets where the deficits could be financed by selling bonds to the public </li></ul><ul><li>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 </li></ul><ul><li>This practice is known as monetization of budget deficits </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 3: Design Flaws and
Free Riders <ul><li>Within the ruble area, the Bank of Russia had a monopoly on printing paper currency </li></ul><ul><li>However, all 15 central banks could create bank credit, causing growth of the money stock </li></ul><ul><li>This gave rise to a free rider problem: </li></ul><ul><ul><li>Each country could use central bank credit to finance its budget deficit </li></ul></ul><ul><ul><li>The resulting inflation was transmitted among all 15 member countries </li></ul></ul><ul><ul><li>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 </li></ul></ul>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?
<ul><li>Reasons to stay . . . </li></ul><ul><li>The ruble might help maintain trade ties with Russia and other neighbors </li></ul><ul><li>Your country might not be ready to administer its own currency successfully </li></ul><ul><li>You might want to exploit free rider opportunities to finance your deficit </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Reasons to leave . . . </li></ul><ul><li>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 </li></ul><ul><li>You might want to shift trade away from Russia and other former Soviet states </li></ul><ul><li>You might want your own currency as a symbol of your newly-gained independence </li></ul>As of mid-1992, the pros and cons of staying in the ruble area looked like this . . .

The Demise of the Ruble
Area <ul><li>Starting in mid-1992, countries left the ruble area one by one </li></ul><ul><li>The Baltic states went first </li></ul><ul><ul><li>Stronger institutions </li></ul></ul><ul><ul><li>Wanted to stop inflation </li></ul></ul><ul><ul><li>Wanted to redirect trade westward </li></ul></ul><ul><ul><li>Strong nationalistic motivation </li></ul></ul><ul><li>In July 1993 Russia replaced the old Soviet ruble with a new Russian ruble, making the ruble area less attractive to others </li></ul><ul><li>Tajikistan, torn by civil war, was the last to leave, in May 1995 </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Ruble vs. Euro: Monetary Free
Riders and Safeguards <ul><li>Monetary free riders in the ruble area . . . </li></ul><ul><li>The Bank of Russia, as the leading central bank of the ruble area, maintained a monopoly only on issue of paper currency </li></ul><ul><li>Other central banks could freely create bank credit </li></ul><ul><li>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 </li></ul><ul><li>Free rider problem was one of the factors that brought down the ruble area </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Safeguards in the euro area . . . </li></ul><ul><li>European Central Bank maintains complete control over both paper currency and credit conditions </li></ul><ul><li>Central banks of euro countries act only as agents of the ECB, cannot act as free riders in money creation </li></ul><ul><li>Some concerns remain about opportunities to seek national advantage in the area of bank regulation, where member countries have more authority </li></ul>

Fiscal Fee Riders and Safeguards
in the Euro Area <ul><li>Fiscal free riders in the euro area </li></ul><ul><li>Euro area governments retain principal authority over fiscal policy </li></ul><ul><li>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 </li></ul><ul><ul><li>If ECB needs to raise interest rates to offset excessively expansionary fiscal policy, it must do so for all members </li></ul></ul><ul><ul><li>Unsustainable deficits by one country may undermine confidence in stability of the euro area as a whole and worsen borrowing conditions for all members </li></ul></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Safeguards are not adequate. . . </li></ul><ul><li>EU rules limit deficits to 3% of GDP and debt to 60% of GDP, but it has proved impossible to enforce these rules </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul>

Why Some Countries Might Want
to Leave the Euro <ul><li>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 </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why Weak Economies Would Find
it Hard to Leave the Euro <ul><li>Under current conditions, weak economies would find it hard to leave the euro in order to devalue </li></ul><ul><li>Devaluation would cause inflation </li></ul><ul><li>Devaluation would make it harder to pay public and private debts and could trigger a default </li></ul><ul><li>After default, it might be hard to reenter world financial markets </li></ul><ul><li>As people came to expect exit, there could be a run on banks as residents shifted deposits to banks in other euro-area countries </li></ul>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 <ul><li>Relatively strong countries like the Baltics left the ruble area early and quickly brought inflation under control </li></ul><ul><li>Independent currencies helped stabilize local financial systems </li></ul><ul><li>Stabilization made it easier, not harder, for countries leaving the ruble to attract foreign finance for public and private debts </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Lessons for the Euro from
the Ruble Experience <ul><li>Lesson 1: Beware the free rider problem . . . </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul>Post P100703 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Lesson 2: Exit barriers are not symmetric </li></ul><ul><li>It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs </li></ul><ul><li>These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area </li></ul>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.