Earlier this month I took you through the graveyard of Europe’s many monetary unions.
We only had time for the old ones though. The eurozone system failed many times before it even began properly. The currency snake and the European Exchange Rate Mechanism (ERM) were dumped by so many countries it’s remarkable anyone signed up to the euro…
But today we ask a follow up question. What can we learn from the breakup of Europe’s past monetary unions to help us understand what’s going on today?
Given all the forces pulling monetary unions apart, they all fail eventually. The real question is who moves first. Who leaves the monetary union first?
History tells us that something called “first mover advantage” plays a big role when a monetary union collapses. European thinktank Bruegel explains:
… those who leave the ‘sinking ship’ first suffer less from macroeconomic instability than those who stay in the CCA [common currency area] to the end. The relative advantages of fast unilateral exit (together with ability to establish prudent monetary regime on its own) are illustrated here through closer analysis of Czechoslovakia after collapse of the AustroHungarian Empire, Slovenia after collapse of Yugoslav federation and the Baltic states after collapse of the USSR.
For now, suggesting leaving the eurozone is a political no-no. But Italy’s governing parties came to prominence suggesting just that. And Brexit is demonstrating it is plausible to break away from the European project.
The breakdown of the Soviet Union’s rouble zone also featured some of the developments we see in the news today. Italy’s mini-BOT parallel currency, also considered by Greece, popped up in Ukraine, Lithuania and Azerbaijan, reports Bruegel:
Although Russia retained its monopolist position in the emission of cash rubles, other [former Soviet Union] countries such as the Ukraine, Lithuania and Azerbaijan began to introduce parallel cash currency (coupons) to circumvent Russian constraints and ‘protect’ their domestic consumer markets (which continued to suffer from physical shortages of goods) against buyers from other republics.
In his book The Euro Trap, Hans-Werner Sinn points out that the failure of the rouble zone confirmed the nature of the Target2 black hole I’ve written about many times in Capital & Conflict: “The end of the system was a great mess, and Russia was unable to have its claims settled.”
This suggests that countries with positive Target2 balances won’t be repaid. Northern Europe will have to write off the “loans” to the south. They will never receive anything of value in return for all those exports they sent south in exchange for Target2 claims.
To be clear, it’s the German central bank which weathers the losses. And thereby the German country as a whole.
But the rouble zone’s collapse also has plenty of good news. Three American economists who studied its collapse concluded “that many of the losses from departing from the zone are very short term. Consequently, they may be dominated by the long-term gains from stabilization that departure from the zone may afford.”
In other words, life is so much better outside a currency union that it’s worth the short-term losses.
Just look at Greece in the news today. The rescue was crushing. What would a departure from the euro have meant?
More on Greece below.
Political will is fickle
Monetary unions do not fail because of economics. They fail because economics drives politics to abandon them.
Once you understand the economics, you need to watch the politics for clues about when things will go wrong, not economic indicators. Bruegel agrees with this after its analysis of the rouble zone:
The history of the ruble area and its collapse highlights the role played by the political determinants of monetary union, whether this be a centralised political power on a given territory (as in case of the former USSR); or a political agreement between largely sovereign states (as in case of the euro area).
Once such political foundations disappear, a common currency does not have any chance of surviving. In such situations, monetary disintegration becomes inevitable. This should take place as quickly as possible in an orderly and collaborative manner (the case of the separation of the former Czecho-Slovak crown in February 1993 serves as good example to follow).
Marek Dąbrowski from the Centre for Social and Economic Research also agrees:
Looking retrospectively, attempts to maintain the common ruble area seem to be very naive. Apart from all purely economic arguments about possible advantages of keeping the common currency area (which are also not obvious in the case of FSU) they missed completely the political realities.
The latter were the following: strong political consensus in respect to monetary and fiscal targets, the common institution in charge of implementing these targets, and some minimum of common legislation (concerning the banking and foreign exchange regulations) are absolutely necessary conditions to have a common currency. These conditions were not present after dissolution of USSR. Moreover, they were not present already in 1991 or even in the end of 1990 when the process of monetary disintegration really started.
Watching the European Union’s internal politics about matters such as immigration, budgets and Brexit is important if you want to predict the failure of the euro. Because as the EU weakens, so will the political will to remain in its currency union.
You might notice that the EU is working on common banking regulation, specifically mentioned by economists who study monetary unions as a requirement for a functioning monetary union. But there’s no agreement on or adherence to fiscal targets, another requirement. Italy’s coming budget battle is in the news too.
Institutions and historians that don’t learn from history
International institutions like the International Monetary Fund (IMF) were caught by surprise when the rouble zone collapsed. Believe it or not, the IMF even tried to revive an alternative version of the rouble zone in 1992. And it didn’t learn its lesson then either.
In 2016, an internal review of the IMF’s handling of the Greek sovereign debt crisis led to this headline in the Telegraph: “IMF admits disastrous love affair with the euro and apologises for the immolation of Greece”. The story begins with this paragraph:
The International Monetary Fund’s top staff misled their own board, made a series of calamitous misjudgments in Greece, became euphoric cheerleaders for the euro project, ignored warning signs of impending crisis, and collectively failed to grasp an elemental concept of currency theory.
Do you think they’ve learned their lesson?
We’re about to find out.
In his summary of past failed monetary unions, Jens Nordvig also comes to a bizarre conclusion. Having proven that monetary unions are destined to fail, he concludes the eurozone is… different.
As far as I can tell, Nordvig is not being sarcastic. Perhaps he was pitching for the award the article ended up winning him. But let’s look at why he thinks it’s unfair to compare the eurozone with past failures.
Is it because the eurozone is designed differently? The architects learned from the many failures of the past and designed a better system?
Nope. The eurozone is different and will not fail for two reasons. Firstly, it is bigger, more developed and trade is more integrated than ever before. And secondly because there is a rather extraordinary amount of euro denominate debt at stake. In other words, if the euro failed, it’d be an extraordinary mess. The biggest financial crisis in history, you might say…
Arguing that the euro cannot fail because the consequences would be too awful is a bit odd. But it does highlight that it really is politics that holds things together. And so it must be politics that pulls them apart.
Until next time,
Nick Hubble
Capital & Conflict
Category: The End of Europe