Policy Brief. Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups. Anders Åslund NUMBER PB12-20 AUGUST PDF

Policy Brief NUMBER PB12-20 AUGUST 2012 Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups Anders Åslund Anders Åslund is a leading specialist on postcommunist economic transformation

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Policy Brief NUMBER PB12-20 AUGUST 2012 Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups Anders Åslund Anders Åslund is a leading specialist on postcommunist economic transformation with more than 30 years of experience in the field. He predicted the fall of the Soviet Union in his Gorbachev s Struggle for Economic Reform (1989). In How Russia Became a Market Economy (1995) he argued that the only choice Russia had was market reform. Other recent books include How Latvia Came through the Financial Crisis (2011), co-authored with Latvian Prime Minister Valdis Dombrovskis, and The Last Shall Be the First: The East European Financial Crisis (2010). Åslund joined the Peterson Institute for International Economics as senior fellow in He has worked as an economic adviser to the Russian government ( ), to the Ukrainian government, and to the president of the Kyrgyz Republic. He was the director of the Russian and Eurasian Program at the Carnegie Endowment for International Peace, and he codirected the Carnegie Moscow Center s project on Post-Soviet Economies. He is chairman of the Advisory Council of the Center for Social and Economic Research (CASE), Warsaw. Author s Note: I am deeply indebted to substantial and insightful comments from Fred Bergsten, Peter Boone, William Cline, Joseph Gagnon, Gary Hufbauer, Simon Johnson, Jacob Kirkegaard, Juan Carlos Martinez Oliva, Adam Posen, Howard Rosen, Arvind Subramanian, Edwin Truman, Angel Ubide, Nicolas Veron, and John Williamson. I have benefited greatly from a staff seminar at the Peterson Institute. I am grateful for excellent research assistance from Natalia Aivazova and editing by Madona Devasahayam. I have done two small pieces on this topic (Åslund 2011 and 2012). Any remaining mistakes are mine. Peter G. Peterson Institute for International Economics. All rights reserved. One of the big questions of our time is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, but I argue that any country s exit from the euro area would be a far greater event with potentially odious consequences. Exit from the EMU cannot be selective: It is either none or all. The breakup of a currency zone is far more serious than a devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. A new payments mechanism may take years to establish, as was the case in the former Soviet Union. Meanwhile, the collapse may lead to a host of disasters. Almost half the cases of hyperinflation in the world took place in connection with the disorderly collapse of three European currency zones in the last century: the Austro-Hungarian Empire, Yugoslavia, and the Soviet Union. It is easier to establish a monetary union than to break it up. In this policy brief, I focus on lessons that can be learned from the breakup of the ruble zone, in which I participated actively. 1 I have three objectives. First, I clarify what a devastating event a possible collapse of the EMU with its large uncleared imbalances could be. Default need not necessarily lead to departure from the euro area. Greece has already defaulted on its official debt to reduce its total public debt to a more sustainable level, but it has not left the euro area. I argue that a Greek exit would not be merely a devaluation for Greece but would unleash a domino effect of international bank runs and disrupt the EMU payments mechanism, which would lead to a serious, presumably mortal, disintegration of the EMU. It 1. I served as a senior economic advisor to the Russian government from November 1991 until January One of my primary preoccupations, together with late acting Prime Minister Yegor Gaidar and late Finance Minister Boris Fedorov, was to break up the currency zone to the benefit of Russia. The reason was that the political preconditions for a monetary union had disappeared Massachusetts Avenue, NW Washington, DC Tel Fax would inflict immense harm not only on Greece but also on other countries in the European Union and the world at large. Second, the critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system. Target2 stands for Trans-European Automated Real-Time Gross Settlement Express Transfer System. It is simply the second version of this payments system now in use (Bindseil, Cour-Thimann, and König 2012, 85). Exit of any country is likely to break this centralized EMU a Greek exit would not be merely a devaluation for Greece but would unleash a domino effect of international bank runs and disrupt the EMU payments mechanism, which would lead to a serious, presumably mortal, disintegration of the EMU. payments mechanism. These rising uncleared balances are a serious concern because nobody can know how they will be treated if the EMU broke up. Any attempt to cap them would risk disruption of the EMU. These balances need to be resolved but in a fashion that safeguards the integrity of the EMU. However, as I show, this can hardly be done by anything less than fully securing the sustainability of the EMU. Third, if the impermissible happens and the euro area breaks up, the damage will vary greatly depending on the policies pursued. On the basis of prior dissolutions of currency zones, I suggest that an amicable, fast, and coordinated end of the EMU would minimize the harm. The first section reviews the arguments for a breakup of the euro area. The second section scrutinizes prior dissolutions of currency zones. Section three gathers estimates on the possible costs of the breakup of the EMU, and section four examines the problems with Target2. Section five outlines how a likely domino effect of the exit of one country could lead to the collapse of the EMU as a whole. Section six considers how the euro area would best be dissolved, if the undesirable would become necessary. The discussion about the euro crisis is broad and extensive. But in this policy brief, I focus only on the issues specified above. I leave aside the many current questions about crisis management, financing, and governance of the EMU. REVIEWING ARGUMENTS FOR A BREAKUP From the outset, many prominent Anglo-American economists, notably Milton Friedman and Martin Feldstein, have been of the view that the euro area could never work. The original arguments, well presented by Nouriel Roubini (2011), are straightforward. First, the euro area did not comply with the original conditions formulated by Robert Mundell for an optimum currency area. The essence of Mundell s (1961, 661) argument was that the optimum currency area is the region defined in terms of internal factor mobility and external factor immobility. Several EMU members have severely regulated labor markets. Second, [a]ll successful monetary unions have eventually been associated with a political and fiscal union (Roubini 2011). These arguments are valid, but supporters of the EMU have countered that the optimum currency area conditions as well as the political and fiscal union that is, a federalization of the European Union could evolve over time and should come to fruition in this crisis. Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund (Bergsten and Kirkegaard 2012). The EMU has not been credible with regard to fiscal discipline and hard budget constraints, and the market has rightly presumed that all national sinners would be bailed out. The current crisis has enhanced the fiscal credibility of the EMU but has instilled new fears of sovereign defaults and currency risks. Two major problems in the euro crisis have aroused new calls for the breakup of the euro area (see, for example, Lachman 2010, Roubini 2011). One is sovereign default. Many presumed that an EMU country that defaulted would have to leave the euro area, but that is not true. Greece has defaulted on its sovereign debt, but it remains in the euro area. As Martin Wolf (2011a) observes, debt restructurings are quite likely, any sort of break-up much less so. With Greece having set an example, it would be natural to expect further write-offs of debt. Carmen Reinhart and Kenneth Rogoff (2009) have empirically established that a developed economy with more than 90 percent of GDP in public debt can barely manage it; that ceiling is at 60 percent of GDP for emergingmarket economies. Given that Greece, Italy, Ireland, and Portugal all have more than 100 percent of GDP in public debt, more official reductions of public debt seem likely, but as in the Greek case such defaults are no reason to exit the EMU. The other problem is that the South European countries are not sufficiently competitive to balance their current 2 account with the northern members of the EMU. Roubini (2011) states, there is really only one other way to restore competitiveness and growth on the periphery: leave the euro, go back to national currencies and achieve a massive nominal and real depreciation. After all, in every emergingmarket financial crisis that restored growth a move to flexible exchange rates was necessary and unavoidable on top of official liquidity, austerity and reform, and in some cases, debt restructuring and reduction. These rising uncleared balances are a serious concern because nobody can know how they will be treated if the EMU broke up. Any attempt to cap them would risk disruption of the EMU. First of all, this statement is not true. While beneficial in some cases, devaluation is by no means necessary for crisis resolution. About half the countries in the world have pegged or fixed exchange rates. During the East Asian crisis in 1998, Hong Kong held its own with a fixed exchange rate, thanks to a highly flexible labor market. The cure for the South European dilemma is available in the European Union. In the last three decades, several EU members have addressed severe financial crises by undertaking serious fiscal austerity and reforms of labor markets, thus enhancing their competitiveness, notably Denmark in 1982, Holland in the late 1980s, Sweden and Finland in the early 1990s, all the ten postcommunist members in the early 1990s, and Germany in the early 2000s. Remember that as late as 1999, the Economist referred to Germany as The sick man of the euro. 2 More recently, the three Baltic countries, Estonia, Latvia, and Lithuania, as well as Bulgaria have all repeated this feat (Åslund 2010, Åslund and Dombrovskis 2011). Among these many crisis countries, only Sweden and Finland devalued, showing that devaluation was not a necessary part of the solution. The peripheral European countries suffer in various proportions from poor fiscal discipline, overly regulated markets, especially labor markets, a busted bank and real estate bubble, and poor education, which have led to declining competitiveness and low growth. All these ailments can be cured by means other than devaluation. Second, any choice of economic policy must be based on a realistic comparison between the alternatives. The EMU 2. The Sick Man of the Euro, Economist, June 3, was designed to be irreversible (Issing 2008), which means that it comes with a number of very costly poison pills. By Maastricht standards, it was a mistake to let Greece into the EMU, but that is not relevant today, because the decision to accept Greece is not reversible. I argue below that the cost of euro area breakup would be horrendous, while the resolution of the South European competitiveness problem is technically comparatively prosaic and devaluation is not a necessary tool to accomplish that goal. Basically, the arguments for a breakup of the EMU boil down to two points: that its governance cannot be fixed or that Southern Europe cannot undertake labor market reforms or carry out wage cuts. For Greece, the only real advantage from an exit would be the possibility to devalue its new currency to become competitive. Yet, without a Latvian-style internal devaluation, Greece would also forgo many desirable structural reforms. After two years of rigorous reforms economic growth has returned to Latvia (Åslund and Dombrovskis 2011). An independent monetary policy would hardly be an advantage for Greece if it were to end up in a devaluation-inflation cycle, which is what one would expect. The negative effects, by contrast, would be massive, both for Greece and other countries because an exit of any country is likely to lead to a full breakup of the EMU, a profoundly different kind of event. As Wolfgang Münchau (2012) writes: A collapse [of the EMU] would constitute the biggest economic shock of our age. In this policy brief I clarify why that will be the case. In one case, though, the EMU might be beyond salvation and thus not worth saving. It would be in the implausible case of inflationary forces taking over the European Central Bank (ECB), as happened with the Central Bank of Russia in Such a development would show that an independent central bank can be perfectly irresponsible and unaccountable and would amount to the ultimate failure of EMU governance. However, I disregard this scenario as too unlikely. PRIOR DISSOLUTIONS OF CURRENCY ZONES The world and Europe have seen the demise of many multinational currency zones. Some have been dramatic, while others have been orderly. In the last century, Europe has experienced at least six breakups of such monetary unions, but they have all been completely different in nature. 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 3 France, Belgium, Italy, and Switzerland and later included Spain, Greece, Romania, Bulgaria, Serbia, and Venezuela. It lasted from 1865 to 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 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. Europe offers one recent example of a successful breakup of a currency zone. The split of Czechoslovakia into two countries was peacefully agreed upon in 1992 to occur on January 1, The original intention was to divide the currency on June 1, However, an immediate run on the currency led to a separation of the Czech and Slovak korunas in mid- February, and the Slovak koruna was devalued moderately in relation to the Czech koruna. Thanks to this early division of the currencies, monetary stability was maintained in both countries, although inflation rose somewhat and minor trade disruption occurred (Nuti 1996; Åslund 2002, 203). This currency union was real, but thanks to the limited financial depth just after the end of communism, dissolution was far easier than will be the case in the future. In particular, no financial instruments were available with which investors could speculate against the Slovak koruna. The situation of the EMU is very different from these three cases. It has no external norm, such as the gold standard, and it is a real currency union with a common payments mechanism and central bank. The payments mechanism is centralized to the ECB and would fall asunder if the EMU broke up because of the large uncleared balances that have been accumulated. The more countries that are involved in a monetary union, the messier a disruption is likely to be. The EMU, with its 17 members, is a very complex currency union. When things fall apart, clearly defined policymaking institutions are vital, but the absence of any legislation about an EMU breakup lies at the heart of the problem in the euro area. It is bound to make the mess all the greater. Finally, the proven incompetence and slowness of the European policymakers in crisis resolution will complicate matters further. 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. 3 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 (Åslund 2007, 60). 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 (World Bank 2011). 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, which is far more than the lost decade in Latin America in the 1980s. The causes of these large output falls were multiple: systemic change, competitive monetary emission leading to hyperinflation, collapse of the payments system, defaults, exclusion from international finance, trade disruption, and wars. Such a combination of disasters is characteristic of the collapse of monetary unions. A common reflex to these cases is to say that it was a long time ago, that things are very different now, and that other factors matter. First of all, it was not all that long ago. Two of these economic disasters occurred only two decades ago. Second, hyperinflation was probably the most harmful economic factor, and it is part and parcel of the collapse of a currency zone, regardless of the time period. About half of the hyperinflations in world history occurred in connection with the breakup of these three currency zones. The cause was competitive credit emission by competing central banks before the breakup. Third, monetary indiscipline and war are closely connected. The best illustration is Slovenia versus Yugoslavia. In the first half of 1991, the National Bank of Yugoslavia started excessive monetary emission to the benefit of Serbia. On June 25, 1991, Slovenia declared full sovereignty not least to defend its finances. Two days later, the Yugoslav armed forces attacked Slovenia (Pleskovic and Sachs 1994, 3. The literature on the collapses of these three currency unions is ample, notably, Pasvolsky (1928), Sargent (1986), Dornbusch (1992), Pleskovic and Sachs (1994), Åslund (1995), and Granville (1995). 4 198). Fortunately, that war did not last long and Slovenia could exit Yugoslavia and proved successful both politically and economically. Many economists disregard the experiences of the former Soviet Union and Yugoslavia because both countries also went through systemic changes. In order to control for systemic change I compare the former Soviet Union with Romania and Bulgaria, which also had
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