December 7, 2011 8:55 pm

The terrible consequences of a eurozone collapse

What happens if the euro collapses? A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A full or comprehensive break-up, with the euro area splintering into a Greater Deutschmark zone and about 10 national currencies would create pandemonium. It would not be a planned, orderly, gradual unwinding of existing political, economic and legal commitments. Exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally and competitively weak member states, whose currencies would weaken dramatically and whose banks would fail. If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression.

Consider the exit of a fiscally and competitively weak country, such as Greece – an event to which I assign a probability of about 20-25 per cent. Most contracts, including bank deposits, sovereign debt, pensions and wages would be redenominated in new Drachma and a sharp devaluation, say 65 per cent, of the new currency would follow. As soon as an exit was anticipated, depositors would flee Greek banks and all new lending governed by Greek law would effectively cease. Even before the exit, the sovereign and the banking system would fail because of a lack of funding. Following the exit, contracts and financial instruments written under foreign law would likely remain euro-denominated. Balance sheets would become unbalanced and widespread default, insolvency and bankruptcy would result. Greek output would collapse.


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IN Opinion

Greece would temporarily gain a competitive advantage from the sharp decline in the new Drachma’s value, but like Portugal, Spain and Italy, Greece does not have the persistent nominal rigidities to make it a lasting competitive advantage. Soaring wage and price inflation would restore the uncompetitive status quo. Without external funding, imports would collapse, disrupting domestic production. Aggregate demand and aggregate supply would chase each other downwards.

If Greece storms out of the eurozone there might be little fear other countries would follow suit.

However, if Greece is pushed out of the eurozone because other member states refuse to fund the Greek sovereign and the European Central Bank refuses to fund Greek banks, the markets could beam in on the next most likely country to go. This could prompt a run on that country’s banks and stop funding for its sovereign, financial institutions and companies. Fear might actually then force the departure of the afflicted country. Exit contagion might sweep right through the rest of the eurozone periphery – Portugal, Ireland, Spain and Italy – and then begin to infect the “soft core”of Belgium, Austria and France.

A disorderly sovereign default and eurozone exit by Greece alone would be manageable. Greece accounts for only 2.2 per cent of eurozone area GDP and 4 per cent of public debt. However, a disorderly sovereign default and eurozone exit by Italy would bring down much of the European banking sector. Disorderly sovereign defaults and eurozone exits by all five periphery states – an event to which I attach a probability of no more than 5 per cent – would drag down not just the European banking system but also the north Atlantic financial system and the internationally exposed parts of the rest of the global banking system. The resulting financial crisis would trigger a global depression that would last for years, with GDP likely falling by more than 10 per cent and unemployment in the West reaching 20 per cent or more. Emerging markets would be dragged down too.

Exits by Germany and other fiscally and competitively strong countries could be even more disruptive. This might occur amid attempts to introduce a one-sided fiscal union with open-ended and uncapped euro-bonds or other transfers from the strong to the weak without a corresponding surrender of fiscal sovereignty to prevent future crises or if the ECB were to “go Weimar”. I consider this highly unlikely, with a probability of less than 3 per cent. Following such an exit, Germany and the other core eurozone member states (perhaps excluding France) would introduce a new Deutschmark. The sovereigns in the periphery would default. The new Deutschmark would appreciate sharply. Financial institutions in the new area would have to be bailed out because of losses from exposure to the old periphery and the soft core. As nothing would be holding the remaining eurozone countries together, the rump would split into perhaps 11 national currencies. The legal meaning and validity of all euro-denominated contracts and instruments would be up for grabs. Everyone, except lawyers specialising in the Lex Monetae, would become much poorer.

Even if a break-up of the eurozone does not destroy the EU completely and precipitate the kind of conflicts that disfigured the continent in the past, the case for keeping the show on the road seems rather robust.

The writer is chief economist at Citi

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  1. Report WL - Minneapolis | December 7 11:10pm | Permalink
    Break-up or disbanding the eurozone need not be disorderly. It could also be done in a thoughtful, deliberate, and controlled fashion over a period of a few years time- essentially a reversal of the process that created the eurozone in the first place.
  2. Report abhik mukherjee | December 7 10:43pm | Permalink
    Greece has only 6% of outstanding debt issued under international law.
    For the peripheral countries, its probably better to plan an euro exit than swallow the painful fiscal austerity pill prescribed by Germany.
    Banks are hoarding liquidity for this eventuality. For example sight deposits at the SNB have soared to nearly 19 times the minimum requirement!! Hope citi is too.
    Disappointed with the scare-mongering tone of this article. The time for the euro in its current form is nearly up!
  3. Report bluehorsesandal | December 7 10:42pm | Permalink
    The 'show' is being kept on the road for a good 30yrs and the destination is where we are right now... Don't full yourself William, the Euro 'jacket' and current excessive leverage (bank and sov) is unsustainable. The more you try to hide losses sending good money after bad money the more complex and devastating will be the final outcome. There is a solution indeed. Painful yes but not catastrophic as you mentioned. 1. End of the Euro; 2. Take the losses/mark bank's balance sheets (shareholders and sub bond holders are wipe out); 3. National states take over their banks injecting money (in their local currencies).

    The end of euro needs to happen in 1 weekend (all 17 countries leave in the same day). National currencies reestablished. Capital controls in place (100% tax on capital repatriation for example). Assets and liabilities matched to the same currency (ie. govs assume all external (euro) private debt and become creditor of the same companies and banks in the local currency so companies and banks don’t default by having asset-liability mismatch). Markets closed for a week so people can do the math and remark their assets and liabilities. As I said painful but it would clean up the system, the players that made unwise and irresponsible investment decisions lending huge amount to insolvent countries would suffer but countries and people would have a chance for a re-start.

    William debt relief always happened in human history (Hammurabi, Israel, Egypt, Roman Empire, etc...). Civilization survived, it can and should happen again. It will happen anyway one way or another. I just think that politicians, regulators, lawyers and law makers should be working on how to defuse the 'euro bomb'. A controlled explosion would be much better than an uncontrolled one.
  4. Report Robert. Dow. | December 7 10:41pm | Permalink
    There will be no schadenfreude when this dishonest slow motion train wreck hits the buffers .
    I and millions of honest Europeans who speak 27 different languages am only disgusted by the whole corrupt fraudulent power grab predicated as it is on an engineered mountain of debt that is now allowed to present itself as inevitable unavaoidable and God help us all desirable by the lousy list of politcal non-entities that populate Brussels and Starsbourg and live high on the hog at our expense for doing nothing useful that the man on the street can bvelieve in since 1970

    France and Germany by the sly and knowing incompetence of their oversight, by the lack of any serious economic or financial review when it was most needed, thus by default, lied their way through the formation of the euro.

    It is widely recorded that they themselves broke the terms and conditions and rules and regulations and directives laughingly labelled the Stability Pact.

    For fourteen years the EU was criminally incapable of getting its books audited to any degree of honesty that was acceptable to open international standards. It sacked intimidated and one whistle blower and naysayer after another. Bernard Connolly. Paul van Buitenen. Marta Andreasson. And how many more whom we never heard of ?

    It robbed one nation after another of its democratic mandate re-imposing referenda whenver it didnt get the answer it wanted and it ramped up the collecive debt to levels that are too big to fail and then it cynically and ruthlessly and systemiatically blackmailed its way to where we are now.

    Socialism fouled its own backyard for good with this unholy compact with the practice of issuing all money as debt and when the poverty hits the streets the world will know it and history will record it.

    Seldom has decency and honesty and human liberty of 300 million people been traduced in such a wholesale and blatant manner as this misguided experiment in pushing two such historically mis matched partners as France and Germany further up the mythical tree of power influence and supposed relevance or usefulness to human beings.

    The demographics of global change, the consequent reversal of economic power from West to East, the increasing potential for the new economic powers to simply laugh at the protectionism of the old world with fast approaching certainty.

    These factors and other make your head spin at the lunacy that is Camerons willingness to eat crow so he cant be blamed for any part of the downfall of this corrupt dysfunctional debt ridden farce.

    What price Truth and clarity now ?

    Probably twenty or thirty years of serious depression and in-fighting in Europe whilst the BRICS et al leave us all behind for good.
  5. Report penruddock | December 7 10:34pm | Permalink
    I have saved this ridiculous and slightly pathetic attempt to curdle the blood, and in 20 years' time, when Europe has long since ditched the euro and is far more prosperous than it is today, I will dig it out and laugh at it - again.
  6. Report eminence noire | December 7 10:27pm | Permalink
    prepare for Eurogeddon
  7. Report Pepijn | December 7 10:20pm | Permalink
    All of that is true, but maybe the alternative - keeping the show on the road - is perhaps even more perilous in the long run. The only sustainable way to keep the show on the road will be some sort of transfer union, whereby the North must pay perpetually and the South must accept a loss of souvereignty and chronic economic weakness, perpetually. This could easily lead to a political crisis, tensions and even conflict, all on a worse scale then the type of socio-political unrest a couple of years of 20%+ unemployment rate would cause in case of a global depression caused by a Euro collapse.
  8. Report Attacko | December 7 10:08pm | Permalink
    If this sovereign debt crisis were taking place against a backdrop of a strong european banking system with manageable exposures to failing sovereigns, then I might agree with the unspoken assumption in this article, that the question of the euro's survival boils down to an issue of political will and finding an agreed way to share the pain between creditor and debtor members of the currency union. That doesn't mean it would be easy, but at least the solution would be within grasp.

    Sadly, I fear that the fragility of the banking system combined with the inability of indebted governments to act as convincing lenders of last resort, means that is quite likely that bank collapses and associated runs will eventually take the problem out of the hands of policymakers, no matter how much liquidity is made available by central banks. So we'll end up with an outcome that everyone knew would not be good, but which it was not within anyone's power to avoid. I guess in the 30s people were aware that falling off the gold standard would not be much fun....didn't mean they could avoid it in the long run.
  9. Report the white rabbit | December 7 10:06pm | Permalink
    Mr Buiter your probabilities of breakup are much lower than traded levels (see e.g. INTRADE http://www.intrade...?contractId=713578) of e.g. 65% for some EZ exits by FY14e=> profit opportunity depending on ones conviction level..
  10. Report a greek | December 7 10:04pm | Permalink
    Any sane person would agree with the author.

    Now, back track a bit, and please read again the article that appeared in the Ft site just a week ago, last Wednesday by no less than Dr. Ottmar Issing, one of the most eminent of the wise men in economics Germany has to offer right now.

    Dr. Issing, in direct contrast to the author did not worry about such trivia; he worried on the contrary a lot about ... future trends in long term interest rates, the moral hazard, and the lawlessness of any action which ECB might undertake to stave off such a disaster. I read this article and the blood froze in my veins.

    We are now at the edge of the precipice, most of the civilized world is biting its nails in anticipation of terrible things to come, and still Herr Professor dusted off his textbooks and gave us a brilliant lecture on how detrimental any ECB <bazooka> would be to the fiscal and monetary health of the Eurozone ten years from now. As if there is going to be a Eurozone in ten years, unless utter horror is not averted in days.

    Still, Herr Doktor Issing is revealing in his article. He is revealing that at this terrible moment, in the heart of the the Eurozone the people who still have some power to stop the landslide, are of such miniscule stature that one can only stare in disbelief. So tiny brained nonentities, huddled amidst their pile of dust collecting tomes, have no clue whatsoever of what is happening and what is about to unfold.

    In view of such woeful inadequacy, I strongly recommend to the people of Europe to discover ...religion. If German policy is shaped by such myopic fools, there is nothing standing between us and destruction but God ! So, Catholics, protestants, Orthodox, muslims, zen-buddists and agnostics join each other in prayer. It costs nothing and it is the only thing you can do. Only some extra terrestrial power can credibly stop this doomsday machine these fools have set in motion and are still doing their damndest to keep going !
  11. Report Euroanythinggoes | December 7 9:57pm | Permalink
    So sgience fiction simply tells you that nothing as dramatic can actually happen. Markets hav kinown that all along wich is why the Euro has remained a strong currency. Eventually the EU creditors will do what it takes since they dont want to become 3rd world countries for no real reason. So one should be talking about how the EU is going to deal with the actual economic crisis (like the US and the rest of the world. The sovereign crisis never actually existed it was make believe.
  12. Report Jingouk | December 7 9:24pm | Permalink
    Greece would at a stroke offer highly competitive property, land, tourism and other lifestyle pursuits. Greece cannot do other than reset and grow from that point. It faces destruction if it stays where it is.
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