The Breakup of the Ruble Area (1991-1993): Lessons for the Euro

The recent problems of high-debt countries in Europe--Greece, Spain, and others--have led many observers to wonder if the euro area might break apart. Parallels have been drawn to the collapse of other fixed exchange-rate systems, ranging from the gold standard to the Argentine currency board. Less attention has been paid to what can be learned from the collapse of  the 15-nation ruble area of 1991-1993.

The ruble area came into existence when the Soviet Union was dissolved at the end of 1991. The former republican branches of the Soviet state bank (Gosbank) became the central banks of the 15 newly independent states. Superficially, it looked a lot like the 17-nation euro area.

Unlike the euro area, the ruble area suffered from its birth from high inflation. The inflation arose from three main problems.

• First, there was the legacy of perestroika. Mikhail Gorbachev's failed attempt to reform the Soviet economy led to loss of financial control and growth of nominal demand without corresponding increase of real supply. Administrative price controls led to repressed inflation, which was released in a burst when controls were lifted in January, 1992.
• Second, inflation arose from the monetization of budget deficits. With weak, corrupt, tax systems and no working financial markets to finance deficits through sales of bonds to the public, governments had no choice but to finance their spending with inflationary credits from central banks.
• Third, there was a fundamental design flaw in the ruble area that led to a free rider problem. The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.

Given these flaws, it is not surprising that the ruble area did not last long. Starting with the exit of the three Baltic states in the summer of 1992, one member after another abandoned the ruble and introduced its own legal tender. Russia itself demonetized the Soviet ruble in 1993 and replaced it with a new Russian ruble. War-torn Tajikistan was the last to leave, in 1995.

What relevance does the demise of the ruble area have for today's euro? There are two main lessons.

The first lesson is to beware free rider problems. True, the ECB has more complete control over money creation than the Central Bank of Russia had, so the euro area does not have to worry about monetary free riders. However, it does have a problem with fiscal free riders. Countries that conduct irresponsible fiscal policies, in defiance of EU rules, gain the full short-term political benefits of high spending and low taxes, while shifting at least a part of the resulting costs to their neighbors. Well-intentioned safeguards, including a supposedly strict no bail-out clause, have provided less than full protection against free riders.

The second lesson is that barriers to exit from a currency area are asymmetrical. Much has been made of the fact that countries with weak economies, like Greece, would find it hard to leave the euro. Even a parliamentary debate on exit would be likely to trigger devastating bank runs and defaults on public and private debt. (See Barry Eichengreen for a good, short presentation of this view.)  However, the same barriers do not apply to countries with strong economies that want to leave a weak, inflation-plagued currency area. Estonia, Latvia, and Lithuania achieved a smooth exit from the ruble area. Introducing their national currencies quickly brought down inflation, helped stabilize financial systems, and made it easier, not harder, to attract foreign finance for public and private debt.

All this suggests a possible scenario for breakup of the euro. If a coalition of weak economies were ever to gain control of the ECB, they might be tempted to use inflationary policy to ease their debt burdens and stimulate their economies. Once that happened, stronger economies with greater aversion to inflation--Germany, in particular--might be motivated to leave the euro, and could do so without risk of bank runs or defaults.



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