Currency Unions and Breakups

February 22, 2012

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Variant Perceptions countered prevailing wisdom that a breakup of the union would be a cataclysmic event, showing the history of currency union breakups, leading indicators, and their results. Breakups are typically a surprise, result in capital controls, and surprisingly, have a limited impact on macroeconomic conditions. Economies bounce back within a few quarters. The best leading indicator is inflation differentials, which has implications for the US dollar – Chinese Yuan codependency.

Economists, and foreign bankers, predicted dire consequences following defaults and devaluations in Asia 1997, Russia 1998, Argentina 2002, and Iceland 2008. However, “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth ¡n the periphery ¡s to exit the euro, default and devalue.”

Currency breakups and exits occur frequently: a study of 245 country pairs that use a common currency (of which 128 are dissolved) from 1948 through 1997 to characterize currency union exits. “I find that departures from a currency union tend to occur when there is a large inflation differential between member countries, when the currency union involves a country which is closed to international trade and trade flows dry up, and when there is a change in the political status of a member. In general, however, macroeconomic factors have only little predictive power for currency union dissolutions.”

Andrew K. Rose, a Professor of International Business at the University of California, Berkeley, has done a study of over 130 countries from 1946 to 2005; finding, “there is remarkably little macroeconomic volatility around the time of currency union dissolutions, and only a poor linkage between monetary and political independence. Indeed, aggregate macroeconomic features of the economy do a poor job in predicting currency union exits.”

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