After the Soviet Union was dissolved, the 15 successor states for a time shared the ruble as their common currency. The breakup of the ruble area holds lessons for the euro.

1. Economics for your Classroom
from
Ed Dolan’s Econ Blog
The Breakup of the Ruble
Area (1991-1993):
Lessons for the Euro
Updated June, 2013
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2. Could the Euro Area Break Up?
 Debt crises in Greece, Spain, and
other EU members have raised the
question— could the euro area
break up?
 If so, who would leave first?
Economically weak members like
Greece? Or stronger members like
Germany?
 These slides look at the breakup of
an earlier currency area—the short-
lived ruble area of 1991-1993—and
draw some lessons for the euro
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

3. Collapse of the Soviet Union and Emergence of the Ruble Area
 The Soviet Union was dissolved in
December 1991
 Each of its 15 former member
republics* became independent
 Initially, all 15 shared the Soviet ruble
as their currency, forming a common
currency area superficially similar to
the 17-nation euro area
 The former branches of the USSR
State Bank (Gosbank) became the
central banks of the newly
independent states
*The Baltic countries, Estonia, Latvia, and Lithuania, had
declared independence earlier, in the summer of 1991
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

4. Inflation in the Ruble Area
 Unlike the euro area, the ruble
area suffered serious inflation
from its birth
 Inflation in the ruble area
arose from three major
problems:
1. The legacy of perestroika
2. Monetization of budget
deficits
3. Design flaws leading to a
free rider problem
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

5. Problem 1: The Legacy of Perestroika
 Perestroika was Mikhail Gorbachev’s
failed attempt to reform the Soviet
economy in the late 1980s
 Rapid growth of money and credit
inflated demand, but reforms failed
to increase supply of goods
 Administrative price controls plus
excess demand led to shortages and
long lines in stores
 When price controls were removed
in January 1992, repressed inflation
was released and prices jumped
upward
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

6. Problem 2: Monetization of Budget Deficits
 Weak, corrupt tax systems and other
factors led to large budget deficits
 There were no working markets
where the deficits could be financed
by selling bonds to the public
 Governments had little choice but to
finance deficits with credits from their
central banks, a process that added
to the monetary base, the money
stock, and inflation
 This practice is known as
monetization of budget deficits
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

7. Problem 3: Design Flaws and Free Riders
 Within the ruble area, the Bank of
Russia had a monopoly on printing
paper currency
 However, all 15 central banks could
create bank credit, causing growth of the
money stock
 This gave rise to a free rider problem:
 Each country could use central bank
credit to finance its budget deficit
 The resulting inflation was transmitted
among all 15 member countries
 Each country had an incentive to act as
a free rider, enjoying the benefits of
credit expansion while shifting the
inflationary costs to its neighbors
This chart shows that Ukraine was
especially active in creating ruble area
money in 1992. After mid-1993,
opportunities to play the free rider largely
disappeared
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

8. To stay or to leave?
Reasons to stay . . .
 The ruble might help maintain trade ties
with Russia and other neighbors
 Your country might not be ready to
administer its own currency successfully
 You might want to exploit free rider
opportunities to finance your deficit
Reasons to leave . . .
 Since Russia was not doing a good job
of managing the ruble, you might want
to take control of your own currency to
fight inflation
 You might want to shift trade away from
Russia and other former Soviet states
 You might want your own currency as a
symbol of your newly-gained
independence
As 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/

9. The Demise of the Ruble Area
 Starting in mid-1992, countries left
the 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 old
Soviet ruble with a new Russian
ruble, making the ruble area less
attractive to others
 Tajikistan, torn by civil war, was the
last to leave, in May 1995
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

10. Ruble vs. Euro: Monetary Free Riders and Safeguards
Monetary free riders in the ruble
area . . .
 The Bank of Russia, as the leading
central bank of the ruble area,
maintained a monopoly only on issue of
paper currency
 Other central banks could freely create
bank credit
 Member countries could act as free
riders by financing excessive budget
deficits with bank credit, while shifting
part of the inflationary consequences to
their neighbors
 Free rider problem was one of the
factors that brought down the ruble area
Safeguards in the euro area . . .
 European Central Bank maintains
control over both paper currency and
credit conditions
 Central banks of euro countries act only
as agents of the ECB, cannot act as
free riders in money creation (with some
minor technical exceptions)
 However, there are still many
unresolved problems about bank
regulation and resolution of failed banks
in the euro area
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

11. Fiscal Fee Riders and Safeguards in the Euro Area
Fiscal free riders in the euro area
 Euro area governments retain principal
authority over fiscal policy
 A country that runs excessive budget
deficits gains all the political advantages
from high spending and low taxes, but
shifts part of burden to other euro
countries
 If ECB needs to raise interest rates to
offset excessively expansionary fiscal
policy, it must do so for all members
 Unsustainable deficits by one country
may undermine confidence in stability of
the euro area as a whole and worsen
borrowing conditions for all members
Safeguards are not adequate. . .
 EU rules limit deficits to 3% of GDP and
debt to 60% of GDP, but it has proved
impossible to enforce these rules
 Euro zone rules contain a strict “no bail
out” clause, but this rule seems to have
become a dead letter after bailout
packages for Greece, Ireland, Portugal,
and Cyprus
 In the past, the ECB did not purchase
bonds of individual member countries,
but it has now begun to do so under
pressure of the Greek crisis
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

12. Why Some Countries Might Want to Leave the Euro
 Economic performance of eurozone
countries has been very uneven in many
respects
 For example, this chart shows that some
countries, notably Germany, have
increased their share of world exports
since the introduction of the euro while
others have decreased their share
 Some economists have suggested that
by leaving the euro and devaluing,
lagging countries could improve their
export performance and thereby boost
employment and economic growth
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

13. Why Weak Economies Would Find it Hard to Leave the Euro
 However, weak economies would find it
hard to leave the euro in order to devalue
 Devaluation would cause inflation
 Devaluation would make it harder to pay
public and private debts and could trigger
a default
 After default, it might be hard to reenter
world financial markets
 As people came to expect exit, there
could be a run on banks as residents
shifted deposits to banks in other euro-
area countries
Posted July 3, 2010 (revised Jan. 31, 2011) Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

14. Why Strong Economies Might Find it Easier to Leave
 By comparison, when the ruble area broke
up, relatively strong countries like the
Baltic states were the first to leave
 They quickly brought inflation under control
 Independent currencies helped stabilize
local financial systems
 Stabilization made it easier, not harder, for
countries leaving the ruble to attract
foreign finance for public and private debts
 For the same reasons, stronger economies
like Germany could find it easier to leave
the euro than weak ones
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

15. Lessons for the Euro from the Ruble Experience
Lesson 1: Beware the free rider
problem . . .
 Free riders can undermine a currency
area when they have an incentive to put
national interests above the interests of
the currency area as a whole
 The nature of the free rider problem—
monetary vs. fiscal—was different in the
ruble area from that in the euro area,
but the problem is real in both cases
Lesson 2: Exit barriers are not
symmetric
 It is hard for countries with weak
economies to leave a stable currency
area because doing so can trigger
defaults and bank runs
 These exit barriers do not apply to
countries with strong economies that
want to leave a weak, inflation-ridden
currency area
June 11, 2013 Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

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