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Why a collapse of the Eurozone must be avoided

It has become increasingly fashionable to talk about Europe without the euro. But this column points out that in the last century Europe has seen the collapse of three multi-nation currency zones: the Habsburg Empire, the Soviet Union, and Yugoslavia – and they all ended with disastrous hyperinflation. The lesson for the Eurozone is clear: avoid break up at almost any cost.

Articles on a possible breakup of Eurozone either see it as a mere devaluation (Lachman 2010, Roubini 2011) or reckon that its collapse would amount to a major economic disaster (Buiter 2011, Cliffe et al. 2010, Normand and Sandilya 2011). It seems the latter is more likely. Large imbalances have accumulated between southern debtor countries and northern creditor countries. Any capping of these balances would disrupt the payments mechanism between the Eurozone countries and impede all economic activity (Åslund 2012).

In the last century, Europe saw the collapse of three multi-nation currency zones, the Habsburg Empire, the Soviet Union, and Yugoslavia. They all ended in major disasters with hyperinflation. In the Habsburg Empire, Austria and Hungary faced hyperinflation. Yugoslavia experienced hyperinflation twice. In the former Soviet Union, ten out of 15 republics had hyperinflation (e.g. Pasvolsky 1928, Dornbusch 1992, Pleskovic and Sachs 1994, and Åslund 1995).

The output falls were horrendous and long lasting. The statistics are flimsy, but officially the average output fall in the former Soviet Union was 52%, and in the Baltics it amounted to 42% (Åslund 2007, 60). Five out of twelve post-Soviet countries – Ukraine, Moldova, Georgia, Kyrgyzstan, and Tajikistan – had not reached their 1990 GDP per capita levels in purchasing power parities by 2010. Similarly, out of seven Yugoslav successor states, at least Serbia and Montenegro, and probably Kosovo and Bosnia-Herzegovina, had not exceeded their 1990 GDP per capita levels in purchasing power parities two decades later (World Bank 2011). Arguably, Austria and Hungary did not recover from their hyperinflations in the early 1920s until the mid-1950s. Thus half the countries in a currency zone that broke up experienced hyperinflation and did not reach their prior GDP per capita in purchasing power parities until about a quarter of a century later.

The causes of these large output falls were multiple: systemic change, competitive monetary emission leading to hyperinflation, collapse of the payments system, exclusion from international finance, trade disruption, and wars. Many economists disregard the experiences of the former Soviet Union and Yugoslavia because both countries also went through systemic changes. In an attempt to control for systemic change we can compare the former Soviet Union with Romania and Bulgaria, which also had highly distorted socialist economies and a similar level of economic development as the Soviet Union. By such a comparison, the total output cost because of the slow collapse of the ruble zone might be on the order of 20% to 25%.

The critical issue is the Eurozone payments system. Hans-Werner Sinn initiated a heated discussion about unsettled Target2 clearing balances of the Eurozone in 2011 (e.g. Sinn 2012, Whelan 2011, 2012). Before the current crisis, these balances more or less offset each other or were settled through the private interbank market, which has dried up. As a consequence, large positive Target2 balances have arisen with the national central banks in the four northern Eurozone countries – Germany, the Netherlands, Luxembourg, and Finland – and corresponding big negative balances with eight countries – Italy, Spain, Ireland, Greece, France, Portugal, Belgium, and Austria) (Sinn and Wollmershäuser 2012). The causes of these balances are current-account deficits of the southern countries as well as transfers of bank deposits from the south to the north. These balances exceed €1 trillion, and Germany’s surplus alone corresponds to one-third of Germany’s GDP.

Sinn (2011) has argued that “the Eurozone payments system has been operating as a hidden bailout whereby the Bundesbank has been lending money to the crisis-stricken Eurozone members via the Target system.” He has alternatively proposed to cap the Target2 balances, settle them in hard assets, or transform them into short-term Eurobonds. Karl Whelan (2011) and others oppose Sinn, arguing that the Bundesbank has claims on the ECB system as a whole, not on individual national central banks. Whelan points out that limiting a Target2 balance would amount to cutting out a country from the euro system.

Legally, Whelan’s interpretation is presumably correct, but since the Lisbon Treaty does not contain any stipulations for the dissolution of the Eurozone, it is not evident what law would apply to these balances if it does break up. If the ECB would collapse in the breakup of the Eurozone, the main creditor would no longer exist. Moreover, the southern countries would in all probability default on their bonds in such an event, sharply reducing the value of any collateral held as sovereign bonds.

The accumulation of large uncleared balances of dubious character is symptomatic of a currency zone in crisis. The former Soviet republics formally agreed to coordinate their issue of credit, but they all failed to implement their agreement and competitive credit issue ensued. All the other former Soviet republics had large current-account deficits with Russia. Until the ruble zone collapsed in September 1993 Russia financed them all. In 1992, Russia’s credits to the other former Soviet republics amounted to 9.3% of its GDP. Formally, the gains of the other states were enormous, ranging from 11% of GDP in Belarus and Moldova to 91% of GDP in Tajikistan (IMF 1994, p. 25). In reality, however, no country benefited from this flow of money, which contributed to hyperinflation everywhere (Åslund 1995). Similarly, Slovenia and Croatia had large current-account surpluses in relation to Serbia, which responded by emitting far more credit rather than paying in real terms, which in turn persuaded Slovenia and Croatia to abandon the Yugoslav dinar (Pleskovich and Sachs 1994).

Domestically, post-Soviet Russia had a clearing system that could not manage all the new payments, and large arrears accumulated in the so-called Kartoteka II, where all payments were registered in the order of their entry. The dominant Russian view was that they should be financed with new monetary emission as indeed happened, which resulted in high inflation. Uncleared payment balances anywhere may provoke monetary emission.

Sinn has made an important contribution by drawing attention to these large unsettled balances, but his proposal to cap the national Target2 balances is very dangerous. The Russian reformers set such ceilings on the credits from the Central Bank of Russia to the other post-Soviet countries to limit Russia’s losses and break up the ruble zone, as happened. No such limit on a clearing balance is permissible in a currency zone. Nor is it permissible to ignore these balances, as Whelan seems to suggest, because they can become real.

Sadly, both Sinn and Whelan’s lines of argument are likely to contribute to the disruption of the Eurozone. Sinn’s argument is a straightforward copy of the Russian breakup of the ruble zone, while Whelan ignores the problem of uncleared Target2 balances.

If one country (Greece) departs from the Eurozone or if its Target2 balances are capped, the current slow bank run from the south will accelerate quickly and become a massive bank run from most banks in southern Europe, and the banking system would stop working. The Eurozone payments system would stop functioning because it is centralized to the ECB. To re-establish a payments system is both politically and technically difficult. In the former Soviet Union, it took three years to do so. Currency controls would arise and a liquidity freeze would occur. If the drachma were reintroduced in the midst of a severe financial crisis, its exchange rate would plummet like a stone by probably 75%-80%. High inflation would result and mass bankruptcies ensue because of currency mismatches. Output would plunge and unemployment soar. Greece would experience a new default and other countries would follow.

For all these reasons, Greece or any other financially weak country is unlikely to depart from the Eurozone. In the three hyperinflationary currency union collapses, it was small, wealthy counties that left first: Czechoslovakia from the Habsburg Empire, Slovenia and Croatia from Yugoslavia, and the three Baltic states from the former Soviet Union. The countries that departed early and resolutely were most successful. Hence, the main concern should be whether small, wealthy northern countries want to abandon the Eurozone.

The conclusion is that the Eurozone should be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the Eurozone. In order to maintain the Eurozone Eurozone-wide clearing must be maintained in full. The Target2 balances should be resolved by reforms, not by capping national balances. The only reasons for a breakup of the Eurozone would be that Eurozone governance fails completely or that one nation decides to leave. If the breakup starts, it would be better to agree on a complete and speedy dissolution into the old national currencies.


Åslund, Anders (1995), How Russia Became a Market Economy, Washington: Brookings Institution.

Åslund, Anders (2007), Building How Capitalism Was Built: The Transformation of Central and Eastern Europe, Russia, and Central Asia, Cambridge University Press.

Åslund, Anders (2012), “Why a Breakup of the euro Area Must Be Avoided: Lessons from Previous Breakups”, Policy Brief 12-20, Peterson Institute for International Economics, August.

Buiter, Willem (2011), “The Terrible Consequences of a Eurozone Collapse”, Financial Times, 8 December.

Cliffe, Mark et al. (2010), “EMU Break-up: Quantifying the Unthinkable”, ING, Global Economics, 7 July.

Dornbusch, Rudiger (1992), “Monetary Problems of Post Communism: Lessons from the End of the Austro-Hungarian Empire”, Weltwirtschaftliches Archiv, 128(3):391-424.

International Monetary Fund (1994), Economic Review: Financial Relations among Countries of the Former Soviet Union, IMF.

Lachman, Desmond (2010), Can the Euro Survive?, Legatum Institute, December.

Normand, John, and Arindam Sandilya (2011), “Answers to 10 Common Questions on EMU Breakup”, JP Morgan, 7 December.

Pasvolsky, Leo (1928), Economic Nationalism of the Danubian States, London: George Allen & Unwin.

Pleskovic, Boris, and Jeffrey D Sachs (1994), “Political Independence and Economic Reform in Slovenia”, in Olivier Blanchard, Kenneth Froot, and Jeffrey D Sachs (eds.), The Transition in Eastern Europe, 1, National Bureau of Economic Research, 191-220

Roubini, Nouriel (2011), “The Eurozone Is Heading for Break-up”, Financial Times, 14 June.

Sinn, Hans-Werner (2011), “The ECB’s Stealth Bailout”, VoxEU.org, 1 June.

Sinn, Hans-Werner (2012), “Fed Versus ECB: How TARGET Debts Can Be Repaid”, VoxEU.org, 10 March.

Sinn, Hans-Werner, and Timo Wollmershäuser (2012), “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility”, International Tax Public Finance, 30 May.

Whelan, Karl (2011), “Professor Sinn Misses the Target”, VoxEU.org, 9 June.#

Whelan, Karl (2012), “Target2: Germany Has Bigger Things to Worry about”, VoxEU.org, 29 April.

World Bank (2011), World Development Indicators.

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