There are four traits that UBS identified as common trends around the breakup of a monetary union. So has Cyprus (as is tirelessly pointed out, only 0.2% of the Euro area measured by GDP) set a course for the Euro’s destruction? Indeed, with Cyprus having checked the first three items on that list, while it has not left the Euro (yet), UBS concludes, “it may well be occupying a seat very close to the exit.”
Via UBS: Is Cyprus Still In The Euro?
The four traits are:
- Monetary union break up is preceded by capital flight from perceived weak from perceived strong parts of the union
- Monetary union break up has tended to be regarded by governments as an opportunity for seizing cash or other assets held by citizens
- Capital controls tend to be imposed early in the break up, and foreigners’ asset holdings are often discriminated against
- Break up of a monetary union is normally associated with civil unrest and authoritarian government in at least some part of the former monetary union.
Eighty years of historical repetition
Let us get our worst case scenario out of the way. Cyprus has not left the Euro yet. It may well be occupying a seat very close to the exit, but in spite of having met the majority of the conditions of past monetary union collapses, it has not actually pushed through the door into the outside world. Instead, Cyprus – and perhaps the wider Euro area – can be thought of as occupying a position not too dissimilar to that of the United States in 1932/33, when the US monetary union effectively ceased to exist and then reformed.
The characteristics of monetary union failure are common to nearly all monetary union breakups, but they are not sufficient conditions of themselves. The US monetary union in 1932 experienced the first three conditions associated with a breakup, in that various states legislated bank holidays, limited deposit withdrawals, and restricted the transfer of funds out of state (the last point was generally accomplished by closing the banks). However, it should be noted that unlike Cyprus the movement of physical cash across state boundaries, assuming one had any to start with, was not prohibited in the US.
This process of bank holidays had followed on from an earlier episode of capital flight. Anticipating problems, financially savvy citizens of several states began to move their money into New York banks, as these were perceived as being stronger entities.
However, most economists would consider the US monetary union as functioning until January 1933. The union was certainly strained, and a dollar cash in New York had a different value from a dollar cash in Michigan (for example), but the central part of the monetary union was still functioning. What caused the monetary union to cease was the refusal, in January 1933, of the Federal Reserve Bank in Chicago to discount the bills of the Federal Reserve Bank in New York. One part of the central bank refusing to lend money to another part of the central bank signals pretty much the end of the monetary union.
The current situation in the Euro area has not reached that point, indeed is the antithesis of that. The European Central Bank has clearly been prepared to provide funds to the Cypriot central bank, and the Target 2 system of transfers between central banks is still operational. This is what enables us to say that the Euro remains intact as a monetary union. Should either of those situations change then Cyprus would cease to be a part of the Euro in any practical economic sense.
This does not mean that the Euro has nothing to learn from the events in the United States eighty years ago. The US monetary union breakup was unusual in that it also led to a successful reformation of the monetary union. The means by which this was achieved were twofold: first, establishing confidence in the banking system; second, by creating a fiscal union. The second of these options is not imminent in the Euro (and took several years in the Unites States). However, the first of these options is not only available it is actually under discussion with the concept of a banking union (which would entail a credible lender of last resort).
The idea is something that ECB President Draghi has alluded to repeatedly. In a monetary union there should be differentiation of borrowers by credit quality, of course, but there should not be differentiation by geography alone. The theoretical concept of the Euro sovereign ceiling being AAA regardless of the nationality of that borrower reflects that belief (in reality the theory has not survived the crisis). The reality of the disparate banking systems of the Euro area is that there is geographic discrimination, and the monetary conditions faced by a borrower in Spain are not the same as those faced by a borrower in the Netherlands, and neither faces the monetary conditions faced by anyone in Cyprus. Integrating the banking system of the Euro area, and providing a degree of common assurance across the Eurozone banks, or a subsection of “federal” Eurozone banks, must now be considered an essential next step on the path to Euro survival, in our view.
Events in Cyprus have caused those of us that think the Euro survives to at least question the odds of its survival. The cost of break up and the near certainty of contagion should hold the structure together. But Cyprus does serve as an opportunity to catalyse further necessary reforms with the right leadership. Let us hope the Euro can find its President Roosevelt, and not a President Hoover.