Past breakups of currency unions provide some guideposts to how Europe's deepening financial crisis could end if its leaders can't find a solution. But its case is unique.
History suggests two types of monetary unions survive the longest, says Gabriel Stein, a director of Lombard Street Research, a London-based economic-analysis firm. The first are those where "a whale is tied to a minnow"—like the U.K. and Ireland from the 1920s to the 1970s and Belgium and Luxembourg from the 1920s to the 1990s. The second is where roughly equal-size entities form a fiscal union—like the U.S.
The euro zone doesn't fit into either category.
In a recent series of reports into the dissolution of past common currencies, economists at UBS Investment Research conclude that the cost of breaking up the euro "is so enormous as to be unimaginable."
They identified four key traits in the fragmentation of past currency unions, including "capital flight from perceived weak to perceived strong parts of the union."
The most visible evidence of this today is the "flight to safety" in government bond markets from European countries regarded as weak, like Greece and Spain to those viewed as stronger—chiefly Germany.
More subtly, people are drawing money out of banks in peripheral economies, most notably in Greece, mainly because people are either hoarding euro notes or shifting money to bank accounts in other euro-area economies.
As the crisis intensifies, the pressures on the monetary union can grow. In a study of the breakup of the Czech and Slovak monetary union in 1993, economists Jan Fidrmuc and Julius Horvath say importers and exporters helped bring the matter to a head. Expecting a Slovak devaluation, Slovak importers repaid their debts to Czech exporters as quickly as possible, while Czech importers did the opposite, hoping to settle in devalued currency.
In this case, the economists say nationalism prevailed over economics and the union broke up—even though there was little economic gain from the breakup.
On the other hand, it also shows that not all monetary union breakups have been costly. Another example of a low-cost separation: Ireland's split from the U.K. in 1979. Yet the Czechoslovak and Irish breakups weren't done in a crisis, which economists generally agree is the worst time for a split. "It doesn't have to be a disaster, but the way it's being done in Europe is going to be disastrous," Mr. Stein says.
As in Czechoslovakia and unlike what is now in prospect in Europe, some past monetary unions dissolved after a political breakup, rather than before. The Austro-Hungarian Monetary Union fell apart in 1919 after the fragmentation of the Austro-Hungarian empire following World War I. The ruble zone broke up in 1992-93 after the collapse of the Soviet Union.
The Austro-Hungarian case provides one example of what the UBS economists point to as a second common trait when currency unions fragment: governments use the split as an opportunity to raise revenue by seizing assets of their citizens. Some successor states enforced conversions of deposits over a certain limit into bonds. In the Czech and Slovak case, limits were placed on the amount of cash that could be converted at the outset of the breakup.
A third common trait of breakups is that they usually have to be accompanied by bank holidays and capital controls—to stop capital flight. In today's environment, electronic banking websites would have to go dark during the adjustment to new domestic currencies.
Prospects of a breakup could even trigger anxieties among holders of euro notes, Mr. Stein says. Each note is identified by a national marker before the serial number (Greece's is Y). People might perceive, even in the face of assurances from the authorities, that Greek notes could end up being worth less than those where the serial number is preceded by X (Germany).
A more fundamental modern-day concern follows from the consequences of the unprecedented integration of the euro-zone financial system and the extensive cross-border holdings of assets by financial institutions.
Devaluations would force banks in countries that didn't also devalue to write down their assets, likely forcing governments to intervene to save them. Financial institutions in Germany and other strong countries would suffer hits because of their assets in the weaker economies.
Mr. Stein says close financial integration was evident between Norway and Sweden in their monetary union with Denmark, which broke up in 1905. But there, business contracts had retained references to their national currencies and the countries continued to issue separate banknotes.
On the face of it, the closest precedent of a monetary union without a fiscal union was the Latin Monetary Union based on a treaty of 1865 between Belgium, France, Italy and Switzerland. It was based on a double standard of silver and gold as a base for coinage, and morphed into a gold-standard regime in 1878. But in reality, the UBS economists argue, it was "no monetary union in the modern sense of the word."
UBS analysts identified a fourth and final trait associated with a breakup: deeply dissatisfied populations. "The economic circumstances that surround a monetary union breakup tend to be extremely severe, because the costs of a breakup are so high. This means that at least some part of the monetary union is likely to be subject to risks of significant civil unrest," they argue.
The good news? Past performance is, as investment managers like to say, no guarantee of future results.
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