Economics for your ClassroomfromEd Dolan’s
Econ BlogThe Breakup of the RubleArea (1991-1993):Lessons for the EuroUpdated June, 2013Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are freeto use these slides as a resource for your economics classes together with whatever textbook you are using. If you likethe slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

Could the Euro Area Break
Up? Debt crises in Greece, Spain, andother EU members have raised thequestion— could the euro areabreak up? If so, who would leave first?Economically weak members likeGreece? Or stronger members likeGermany? These slides look at the breakup ofan earlier currency area—the short-lived ruble area of 1991-1993—anddraw some lessons for the euroJune 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 inDecember 1991 Each of its 15 former memberrepublics* became independent Initially, all 15 shared the Soviet rubleas their currency, forming a commoncurrency area superficially similar tothe 17-nation euro area The former branches of the USSRState Bank (Gosbank) became thecentral banks of the newlyindependent states*The Baltic countries, Estonia, Latvia, and Lithuania, haddeclared independence earlier, in the summer of 1991June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Inflation in the Ruble Area
Unlike the euro area, the rublearea suffered serious inflationfrom its birth Inflation in the ruble areaarose from three majorproblems:1. The legacy of perestroika2. Monetization of budgetdeficits3. Design flaws leading to afree rider problemJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 1: The Legacy of
Perestroika Perestroika was Mikhail Gorbachev’sfailed attempt to reform the Sovieteconomy in the late 1980s Rapid growth of money and creditinflated demand, but reforms failedto increase supply of goods Administrative price controls plusexcess demand led to shortages andlong lines in stores When price controls were removedin January 1992, repressed inflationwas released and prices jumpedupwardJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 2: Monetization of Budget
Deficits Weak, corrupt tax systems and otherfactors led to large budget deficits There were no working marketswhere the deficits could be financedby selling bonds to the public Governments had little choice but tofinance deficits with credits from theircentral banks, a process that addedto the monetary base, the moneystock, and inflation This practice is known asmonetization of budget deficitsJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Problem 3: Design Flaws and
Free Riders Within the ruble area, the Bank ofRussia had a monopoly on printingpaper currency However, all 15 central banks couldcreate bank credit, causing growth of themoney stock This gave rise to a free rider problem: Each country could use central bankcredit to finance its budget deficit The resulting inflation was transmittedamong all 15 member countries Each country had an incentive to act asa free rider, enjoying the benefits ofcredit expansion while shifting theinflationary costs to its neighborsThis chart shows that Ukraine wasespecially active in creating ruble areamoney in 1992. After mid-1993,opportunities to play the free rider largelydisappearedJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

To stay or to leave?Reasons
to stay . . . The ruble might help maintain trade tieswith Russia and other neighbors Your country might not be ready toadminister its own currency successfully You might want to exploit free rideropportunities to finance your deficitReasons to leave . . . Since Russia was not doing a good jobof managing the ruble, you might wantto take control of your own currency tofight inflation You might want to shift trade away fromRussia and other former Soviet states You might want your own currency as asymbol of your newly-gainedindependenceAs of mid-1992, the pros and cons of staying in the ruble area looked like this . . .June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

The Demise of the Ruble
Area Starting in mid-1992, countries leftthe 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 oldSoviet ruble with a new Russianruble, making the ruble area lessattractive to others Tajikistan, torn by civil war, was thelast to leave, in May 1995June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Ruble vs. Euro: Monetary Free
Riders and SafeguardsMonetary free riders in the rublearea . . . The Bank of Russia, as the leadingcentral bank of the ruble area,maintained a monopoly only on issue ofpaper currency Other central banks could freely createbank credit Member countries could act as freeriders by financing excessive budgetdeficits with bank credit, while shiftingpart of the inflationary consequences totheir neighbors Free rider problem was one of thefactors that brought down the ruble areaSafeguards in the euro area . . . European Central Bank maintainscontrol over both paper currency andcredit conditions Central banks of euro countries act onlyas agents of the ECB, cannot act asfree riders in money creation (with someminor technical exceptions) However, there are still manyunresolved problems about bankregulation and resolution of failed banksin the euro areaJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Fiscal Fee Riders and Safeguards
in the Euro AreaFiscal free riders in the euro area Euro area governments retain principalauthority over fiscal policy A country that runs excessive budgetdeficits gains all the political advantagesfrom high spending and low taxes, butshifts part of burden to other eurocountries If ECB needs to raise interest rates tooffset excessively expansionary fiscalpolicy, it must do so for all members Unsustainable deficits by one countrymay undermine confidence in stability ofthe euro area as a whole and worsenborrowing conditions for all membersSafeguards are not adequate. . . EU rules limit deficits to 3% of GDP anddebt to 60% of GDP, but it has provedimpossible to enforce these rules Euro zone rules contain a strict “no bailout” clause, but this rule seems to havebecome a dead letter after bailoutpackages for Greece, Ireland, Portugal,and Cyprus In the past, the ECB did not purchasebonds of individual member countries,but it has now begun to do so underpressure of the Greek crisisJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why Some Countries Might Want
to Leave the Euro Economic performance of eurozonecountries has been very uneven in manyrespects For example, this chart shows that somecountries, notably Germany, haveincreased their share of world exportssince the introduction of the euro whileothers have decreased their share Some economists have suggested thatby leaving the euro and devaluing,lagging countries could improve theirexport performance and thereby boostemployment and economic growthJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Why Weak Economies Would Find
it Hard to Leave the Euro However, weak economies would find ithard to leave the euro in order to devalue Devaluation would cause inflation Devaluation would make it harder to paypublic and private debts and could triggera default After default, it might be hard to reenterworld financial markets As people came to expect exit, therecould be a run on banks as residentsshifted deposits to banks in other euro-area countriesPosted 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 brokeup, relatively strong countries like theBaltic states were the first to leave They quickly brought inflation under control Independent currencies helped stabilizelocal financial systems Stabilization made it easier, not harder, forcountries leaving the ruble to attractforeign finance for public and private debts For the same reasons, stronger economieslike Germany could find it easier to leavethe euro than weak onesJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

Lessons for the Euro from
the Ruble ExperienceLesson 1: Beware the free riderproblem . . . Free riders can undermine a currencyarea when they have an incentive to putnational interests above the interests ofthe currency area as a whole The nature of the free rider problem—monetary vs. fiscal—was different in theruble area from that in the euro area,but the problem is real in both casesLesson 2: Exit barriers are notsymmetric It is hard for countries with weakeconomies to leave a stable currencyarea because doing so can triggerdefaults and bank runs These exit barriers do not apply tocountries with strong economies thatwant to leave a weak, inflation-riddencurrency areaJune 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

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