Only the most drunk on hopium (and Absinthe) among us can harbor any doubt that the eurozone, and hence the common monetary union currency the zEURq.bb, can survive without a dramatic change in the current European monetary (and fiscal) structure and an unprecedented overhaul to the status quo. But it can be done: after all there are numerous case studies across history, when various fiat monetary unions either succeeded or failed. Ironically, according to a just released report by UBS' monetary expert Stephane Deo (which we will discuss more later), three of the better such examples ironically can be traced to none other than the good old United States, which, and this may come as a surprise to some of our readers, had several failed monetary union regimes in the past before it finally arrived on the current stable (relatively speaking) "dollar" solution. So here, courtesy of UBS, are the lessons that Europe can hopefully learn (once again) from America's bitter experience in this matter. Because the alternative to success is failure (more on that shortly), and as UBS notes, "The economic and political consequences of a monetary union break up are also so severe as to deter all but the most determined – or to deter all but those already suffering extraordinary economic distress (occasioned by war or by depression)." So without further ado...
The New England Colonies 1744
Before independence, the American colonies of New England had a limited monetary union. Specie payments (gold and silver) dominated, but colonies financed themselves with paper issue as well. Bills of credit were issued, and traded between the colonies at par (that is to say, a bill of credit from one colony would be accepted at face value as a payment in another colony).
This was clearly not a monetary union as we know it today. There was no central bank, no single issuing note authority, and the system was subject to abuse. Abuse was exactly what happened – Rhode Island started printing money aggressively (between 1710 and 1744 bills of credit from Rhode Island grew on average 14.4% per year, and most of them wound up in the other colonies). As a result the various states, starting with Massachusetts in 1749, passed laws prohibiting the circulation of other states bills of credit within their own borders.
There is little to be learned from this episode for modern analysis. This was a currency union of convenience – a temporarily fixed exchange rate system that broke down under the pressure of one economy printing too much of its own “currency”. It was never a monetary union in a proper sense.
The United States 1861
The onset of the US civil war saw the Confederacy issuing its own fiat currency (known as the Grayback, owing to the rather primitive printing process which produced a limited colour scheme). This was not an overwhelming success – despite the precaution of bearing a signature on every note, it was readily forged.
The Union issued its own fiat currency, the Greenback. California, meanwhile, while part of the Union also allowed contracts to specify that payment would have to be in specie. This “Goldback” currency was (in the view of the Union Treasury secretary) in defiance of the laws governing legal tender in the Union – because a creditor could refuse payment of a thousand dollars of Greenbacks (face value) and insist on payment of a thousand dollars of gold.
The breakup of the US monetary union is an interesting development, because essentially a specie based system was replaced by distinct fiat currency regimes (except in the West). The legal tender status was enforced by law (until such time as the Confederacy ceased to exist, when of course the Grayback lost any status). However, there is little to be learned for the Euro today. This was the introduction of a new fiat currency (or two fiat currencies) that was, theoretically, an extension of the existing specie based dollar. No fiat monetary union broke up as such, because no fiat currency union existed prior to the war (and indeed the creation of fiat currencies was highly controversial. The Union Treasury Secretary, Salmon P. Chase, who introduced the Greenback was also the man who as Chief Justice of the Supreme Court subsequently ruled the Greenback to be unconstitutional).
And the most interesting...
United States 1932 / 33
The break up of the US monetary union in 1932 / 1933 is in many ways an odd episode in the history of monetary unions. It was a break up without new currencies being issued (at least, not in a formal sense). It was also a break up that did not last – the union was reformed in 1933 under the new administration of President Roosevelt.
Although the dollar continued to be the single currency of the United States, and circulated as a fiat currency (albeit one backed by gold), in effect individual states legislated against the monetary union. The banking crises of 1931 saw over half the failures (weighted by deposits) take place in the Federal Reserve districts of Chicago and Cleveland. By the end of 1932, across the union companies were starting to transfer deposits out of local banks and into New York based banks. States began to declare bank holidays – effectively attempting to prevent the transfers – but this only accelerated the process of transfer in those states that kept their banks open. The Michigan bank holiday served as an accelerant. The New York Fed lowered bill purchase rates, but because it was return of capital rather that return on capital that mattered there was no noticeable effect on the pressure of inflows.
In January 1933 the Federal Reserve in Chicago refused to discount the bills of (i.e. lend money to) the Federal Reserve in New York. At this point the monetary union had effectively ceased to operate with any degree of coherence – and banking system regulations were de facto imposing capital controls at state boundaries. By the Roosevelt inauguration in March 1933 thirty five states had bank holidays, and most of the rest had limited withdrawals from their banking systems. The dollar still existed, and was still legal tender, but it was practically impossible to move it across a state boundary except in physical form (and it was increasingly difficult to obtain in physical form). Barter began to replace currency as a medium of exchange.
The situation was remedied with a federal bank holiday in March 1933 – which effectively shut down the entire monetary union for a period of two weeks. Banks then reopened gradually, and interstate transfers where once again possible.
The US example is of interest to the Euro area not because it succeeded, but because the monetary union held together. A combination of labour mobility, banking reform and recapitalisation, and a more complete fiscal union allowed the monetary union to be reconstituted on a more workable footing.
In terms of lessons for a breakup, the process of effectively shutting banking systems at a state level (or limiting deposit withdrawals in some cases) allowed a de facto breakup of the union to occur by imposing what were to all intents capital controls on state borders. Any attempt to secede from the Euro would, inevitably, involve some similar operation. The lessons of 1932/3 may also be instructive as a guide to handling a Greek default. With the fear of contagion focusing on the banking system within the Euro area, declaring a bank holiday or limiting withdrawals from banks across the Euro zone while politicians finalise a more effective solution may be a successful interim measure. It is not a solution, of course (no more than it was a solution with the Federal holiday in 1933), but it gives additional time in which a solution may be found.