Friday, August 10, 2012

European Currency Union Breakups: Lessons for the Euro

The euro isn't the first currency area to risk breaking up.  Anders Åslund makes the case as to "Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups," written as Policy Brief PB12-20 for the Peterson Institute of International Economics.

Åslund focuses in particular on six breakups of monetary unions in Europe in the last century. He argues that three of them are not especially relevant to the euro situation. (Citations are omitted throughout for readability.) "It was rather easy to dissolve a currency zone under the gold standard when countries maintained separate central banks and payments systems. Two prominent examples are the Latin Monetary Union and the Scandinavian Monetary Union. The Latin Monetary Union was formed first with France, Belgium, Italy, and Switzerland and later included Spain, Greece, Romania, Bulgaria, Serbia, and Venezuela. It lasted from 1865 to 1927. It failed because of misaligned exchange rates, the abandonment of the gold standard, and the debasement by some central banks of the currency. The similar Scandinavian Monetary Union among Sweden, Denmark, and Norway existed from 1873 until 1914. It was easily dissolved when Sweden abandoned the gold standard. These two currency zones were hardly real, because they did not involve a common central bank or a centralized payments system. They amounted to little but pegs to the gold standard. Therefore, they are not very relevant to the EMU."

The division of Czechoslovokia in 1992 into two countries with their own currencies also went smoothly, in part because financial connections were limited under the previous communist regime.  "In particular, no financial instruments were available with which investors could speculate against the Slovak koruna."

However, three other European currency breakups are more relevant to the euro, and more concerning, because they all led to steep recessions and hyperinflations.
 "The three other European examples of breakups in the last century are of the Habsburg Empire, the Soviet Union, and Yugoslavia. They are ominous indeed. All three ended in major disasters, each with hyperinflation in several countries. In the Habsburg Empire, Austria and Hungary faced hyperinflation. Yugoslavia experienced hyperinflation twice. In the former Soviet Union, 10 out of 15 republics had hyperinflation. The combined output falls were horrendous, though poorly documented because of the chaos. Officially, the average output fall in the former Soviet Union was 52 percent, and in the Baltics it amounted to 42 percent. According to the World Bank, in 2010, 5 out of 12 post-Soviet countries—Ukraine, Moldova, Georgia, Kyrgyzstan, and Tajikistan—had still not reached their 1990 GDP per capita levels in purchasing power parities. Similarly, out of seven Yugoslav successor states, at least Serbia and Montenegro, and probably Kosovo and Bosnia-Herzegovina, had not exceeded their 1990 GDP per capita levels in purchasing power parities two decades later. Arguably, Austria and Hungary did not recover from their hyperinflations in the early 1920s until the mid-1950s. Thus the historical record is that half the countries in a currency zone that breaks up experience hyperinflation and do not reach their prior GDP per capita as measured in purchasing power parities until about a quarter of a century later ..."

As Åslund notes, one might dismiss these historical parallels by saying that these examples are too far in the past (the Hapsburg empire), or are too interrelated with the breakup of Communist economic regimes (the Soviet Union and Yugoslavia). Thus, he is at some pains to spell out just how and why these consequences could easily happen in modern Europe. For example, he cites one estimate that "the overall decline in output in the EMU countries of a complete breakup of the EMU at 5 to 9 percent during the first year and at 9 to 14 percent over three years." But his purpose is not to defend the specific numbers, but rather to spell out out what happens in a scenario where countries revert to national currencies as quickly as possible, and need to introduce temporary capital controls during the transition. He quotes five concerns from an earlier study, and then adds a sixth concern of his own. Here are the first five concerns:

"First, “the logistical and legal problems of reintroducing national currencies, while transitional, would be serve and protracted.” Second, “capital flight and distress in the financial system would disrupt trade and investment.” Third, a “plunge in business and consumer confidence would likely be accompanied by a renewed dive in asset prices inside and outside the Eurozone.” Fourth, the “challenge of maintaining fiscal credibility and securing government funding would be intensified. This would call for yet more fiscal tightening measures, particularly for the weaker peripheral Eurozone countries.” Fifth, non–euro area countries would suffer from sharp appreciation of their currencies, “compounding the damage to their export growth.”
Åslund emphasizes yet another concern, that the payments system across the euro countries could be sharply disrupted. These issues lead him to conclude: "The Economic and Monetary Union must be maintained at almost any cost. ... The exit of any single country from the EMU, at the present time
when large imbalances have been accumulated, would likely lead to a bank run, which would cause the EMU payments system to break down and with it the EMU itself."

Åslund is a pragmatist, and thus is willing to contemplate the ways in which a "velvet divorce" of the euro could happen in practical terms. He writes: "If the need for dissolution of the euro area appears
inevitable, all countries should agree on an early exit date. Fortunately, all the euro countries still have fully equipped central banks, which should greatly facilitate the process of recovering their old functions—distribution of bank notes, monetary policy, maintenance of international currency
reserves, exchange rate policy, foreign currency exchange, and payment routines."

But he points out that in terms of practical politics, a smooth dissolution of the euro is highly unlikely: "In the end, no velvet divorce is likely. No serious politician is likely to promote a dissolution of the euro area unless forced to  do so, because no one wants to risk going down in history as the person who destroyed the EMU or the European Union. This is most of all true of German politicians. Th erefore, if the euro area breaks up, a messy collapse is most likely to ensue."