Does Putin’s Proposed Eurasian Currency Union Make Sense?

At a meeting in Kazakhstan last week, Russian President Vladimir Putin proposed a currency union for the members of the Eurasian Economic Union (EAEU). Russia, Kazakhstan, Belarus, and Armenia are the current members, and Kyrgyzstan is scheduled to join later this spring. Does a common currency for the EAEU make sense? Not in economic terms, but perhaps there is a political subtext that makes the proposal more understandable.

Some currency union basics

A currency union is simply a group of countries that share a common currency. The eurozone (EZ) is the best-known example. The much smaller Common Monetary area, based on the South African Rand, is another. The 50 states of the United States are sometimes viewed as a currency union for economic purposes, even though the members are not sovereign countries.

Currency unions have both advantages and drawbacks. On the plus side, currency unions facilitate trade and integration. They reduce the costs of currency exchange for travel and trade. They remove the risk that a change in exchange rates will render import-export deals or foreign investment projects unprofitable before they are completed. They eliminate costs of hedging against currency risks.

The major disadvantage is that a currency union takes away exchange rate changes as an instrument for adjusting to external economic shocks, such as changes in the relative prices of a country’s imports and exports, or sudden surges in capital inflows or outflows.

There is a well-developed theory of optimum currency areas, growing out of a seminal 1961 article by Robert Mundell, that explores the conditions under which the advantages of a union outweigh the disadvantages. Three of the most important conditions are structural similarities, flexible markets, and fiscal centralization.

Structural similarities

Currency unions do not work well unless their members are structurally similar, especially with regard to their patterns of imports and exports. Take the United States and Canada, for example. Canada is an oil exporter and the US is an importer. As such, a fall in world oil prices causes an unfavorable shock to the Canadian economy and a favorable shock to that of the United States.

As long as each country has its own currency, a change in the exchange rate can facilitate adjustment. Over the past year, as oil prices have fallen, the US dollar has appreciated some 20 percent relative to the Canadian dollar. The cheaper currency benefits Canadian industries like tourism and timber, and helps to cushion the negative effect of lower oil prices. If Canada and the US shared a common dollar, the adjustment to changing oil prices would be more difficult.

The countries of the proposed EAEU currency area are very diverse. Russia and Kazakhstan are both oil exporters, but in other respects, they have many structural differences. Belarus and Armenia are oil importers that differ in economic structure both from Russia and from each other. In terms of structural similarity, then, the EAEU offers poor prospects for a currency union.

Flexible markets

Joining a currency area means that one of the most important markets—the foreign exchange market—is no longer available as a mechanism for adjusting to economic shocks. However, sufficient flexibility in other markets can offset that disadvantage. Labor mobility, ease of access to finance, and favorable conditions for forming new businesses make it possible for resources to flow from one economic sector to another within a country and from one country to another within a currency union, providing other pathways for adjustment.

There is no universal measure of market flexibility, but the World Bank’s ease-of-doing-business ranking is a rough indicator. The US ranks as the seventh best country for doing business out of 189 covered by the World Bank, a fact that goes a long way toward explaining why it functions well with a single currency. The eurozone presents a mixed picture.

The easiest place to do business in the EZ, according to the World Bank, is Finland, which ranks ninth on its global list. The worst is Greece, at sixty-one. Italy, at fifty-six, is only a little better. Small wonder that many economists see structural reform of labor markets, financial markets, and obstructive national bureaucracies as essential to the long-run success of the euro.

The proposed EAEU currency area is even more problematic in terms of market flexibility. Tiny Armenia ranks highest on the World Bank list at forty-five. Belarus is next, at fifty-seven. Russia, by far the dominant economy in the group, ranks sixty-second. Kazakhstan, at seventy-seven, ranks even lower. To the extent that the World Bank rankings are an indicator of market flexibility, then, the average rank for the EAEU is worse than the lowest for the EZ.

Fiscal centralism

A substantial degree of fiscal centralization is another factor that contributes to the potential success of a currency union. In the real world, the members of a currency union are never structurally identical, so any economic shocks will affect some parts of the union more strongly than others. Those who suffer most from any given shock cannot resort to a currency devaluation to speed adjustment. Flexible labor and financial markets can help, but so can fiscal support from a central authority.

Consider the case of Florida at the time of the financial crisis of 2008. When the crisis hit, Florida’s overheated housing market collapsed in a wave of foreclosures, personal bankruptcies, and business failures. Bad as things were, though, residents of Florida still received their social security checks, hospitals received Medicare reimbursements, and the worst-hit Floridians that could sign up for food stamps. What would have happened if Florida had been responsible for all of its own retirement, healthcare, and social welfare systems? Probably, it would have gone the way of Greece.

Back in Soviet times, when Russia, Kazakhstan, Belarus and Armenia shared a common currency, they also shared a common fiscal system that financed basic services throughout the union. That system is no more, a fact that significantly reduces the prospects for a successful currency union within the EAEU.

Lessons from the EU

Putin appears to see the proposed currency area as step toward making the EAEU a credible political counterweight to the EU. What he seems not to understand is that by viewing the currency union in political terms, he is copying the very mistake made by European elites when they pushed through their project for the euro. In the 1990s, when the euro project was taking shape, numerous economists warned that EU countries did not have the structural similarity, market flexibility, and fiscal centralism needed to make a currency union work smoothly.

Political leaders shrugged off those warnings. Today, with the eurozone undermined by austerity and teetering on the brink of deflation, they are paying the price. As my colleague L. Randall Wray recently put it, the EZ is “designed to fail.”

European leaders may have hoped that forcing through a currency union for which the continent was not suited would bring political unity, but that has not been the result. Instead, they seem to be getting increased tensions between the North and the South and, in both regions, a rise of extremist parties.

Lessons from the ruble area of the 1990s

Putin might also heed lessons from an episode much closer to home. His proposal for the EAEU is not the first attempt to form a currency union among former Soviet republics. When the Soviet Union broke apart in 1991, all fifteen former members of the USSR continued to use the Soviet ruble as their currency. The former regional branches of Gosbank, the state bank of the USSR, became the central banks of each newly independent state.

The Central Bank of Russia was primus inter pares, holding a monopoly on the issue of paper currency but lacking adequate control over the money stock as a whole.

The result was chaos. As explained in detail here, with no one effectively in charge of monetary policy, inflation raged throughout the ruble area. Attempts by the central banks of individual members to game the system for local advantage only made things worse. The whole project quickly collapsed. Estonia, Latvia and Lithuania were the first to abandon the ruble and introduce their own currencies.

By the end of 1993, all of the former Soviet republics except war-torn Tajikistan (which held on until 1995) had left the ruble. The failed currency experiment contributed to the economic chaos that engulfed Russia during the Yeltsin era and helped to undermine prospects for democracy.

So what is Putin thinking?

All this leaves us wondering what Putin is thinking as he pushes the seemingly unpromising idea of an EAEU currency union. I see two possibilities.

One is that neither Putin nor his advisors have a good grasp of economics. The marginalization of most of the sounder economic thinkers that he listened to earlier in his Presidency favors this interpretation.

The other possibility is that he understands that a currency union among a structurally diverse grouping of sovereign states is a bad idea, but he thinks that he can do something about that pesky problem of sovereignty. In this interpretation, the EAEU currency union is just a foot in the door. The ultimate project is for bringing the ruble to Kazakhstan, Belarus and Armenia—perhaps ultimately to Ukraine, Latvia, and beyond—in the same way he brought the ruble to Crimea.

Kazakh President Nursultan Nazarbayev and Belarus President Alexander Lukashenko, who were present at the meeting with Putin, were reportedly cool to the idea of a currency union. Neither of them is an economist, but both are wily political operators. It is likely that they are aware of the threat to their countries’ sovereignty inherent in the project. Time will tell if they are able to stand up to Putin.

Original post