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The U.S. in 1933: A blueprint for how euro rift could heal

Historical crisis holds lessons for why avoiding a collapse is paramount

By Steve Goldstein, MarketWatch

LONDON (MarketWatch) -- From debt-racked Greece to economic powerhouse Germany, leaders across the euro zone insist that the monetary union that now encompasses 16 nations is here to stay -- even as strains over some countries' finances in Southern Europe send bond prices plummeting and propel the dollar higher.

But what if the euro did collapse?

The near-collapse of the dollar in 1933, and its subsequent recovery, can offer a blueprint for recovery should it happen that the euro breaks up, according to a research note from UBS. See related story on the euro.

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Paul Donovan, a London-based economist, reiterated the house belief that the euro won't break up. The reason, in his view: the costs of breaking up far exceed the benefits.

But Donovan pointed to the dollar's woes in the early 1930s as well as to the Czech-Slovak monetary union collapse as offering parallels with the current crisis in Europe.

The dollar never actually formally ceased to function back in the 1930s. But states began declaring dollar holidays, and companies began transferring deposits from local banks to New York lenders.

Indeed, the Federal Reserve Bank of Chicago had even refused to lend to the Federal Reserve Bank of New York.

'What the U.S experience demonstrates is that a monetary union can effectively fracture, and then come back together, if policy makers are committed enough to creating a viable, cohesive monetary policy.'

Paul Donovan, UBS

"Depositors were effectively signaling that a dollar in New York was worth more than a dollar in Michigan," Donovan said. This happened even as the New York Fed lowered its bill purchase rate to 0.5%.

The way the monetary union was repaired came about as a result of three factors: through a reorganization of the Fed in 1935, fiscal transfers and increased geographic mobility.

"What the U.S experience demonstrates is that a monetary union can effectively fracture, and then come back together, if policy makers are committed enough to creating a viable, cohesive monetary policy," Donovan said.

Similarly, the Czechs and the Slovaks underwent strains when their monetary union broke apart in 1993, in the aftermath of the dissolution of Czechoslovakia, Donovan said.

A Slovak crown was supposed to be worth the same as a Czech crown, but bank depositors took their money out of Slovak institutions and put them in Czech lenders.

What those countries did was impose limits on money withdrawn and restrict gaps in their currencies to, effectively, 10%, by anchoring them to the European Currency Unit, predecessor of the euro.

The result, unlike with the U.S., was the creation of two currencies, but it happened with little economic disruption, Donovan said.

The euro also isn't an optimal currency area, not just as economies are absorbing the current credit crunch very differently but also because there's little labor mobility or wage flexibility.

Fiscal policy -- or as Donovan headlines a subtitle, "Germans should pay for Greek pensions" -- offers a way out.

"Wealthier areas should, indeed must subsidize those parts of the monetary union that are at an economic disadvantage. Fiscal transfers are the price that has to be paid for a monetary union of any meaningful size," the economist wrote.

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12:48 PM EST

February 26, 2010

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