Thinking the unthinkable on a euro break-up

It has suddenly become respectable to ask the question: what would happen if the euro broke up? Last week’s rise in German bond yields signals that a euro break-up is being taken more seriously by investors. I am told that London law firms are allocating large amounts of time to examining the validity, following a break-up, of cross-border contracts written in euros. And, to judge from my own inbox, asset managers are beginning to ask about the economics of how it could occur.

When the euro was created, the process took many years of careful planning. The ECU, a basket of fixed amounts of national currencies, traded for several years in the foreign exchange markets, before its name was changed to the euro on 1 January 1999. There were no sudden revaluations and devaluations to disrupt economic relationships within the currency zone.

This movie cannot now be run backwards. It is hard to imagine the 17 members of the eurozone going through an orderly, decade-long process in which national currencies would first be reintroduced, then gradually allowed to deviate against each other within narrow bands, then ultimately allowed to float freely. I am not aware of any currency system which has broken up in such an orderly manner. Much more probable is a severe crisis, followed by the reintroduction of some national currencies, after which the “euro” might be retained by a remaining group of its current members, or it might simply cease to exist altogether.

For investors, a great deal would depend on exactly how this process would unfold. There are far too many possible paths, each with an entirely different outcome, for this to be in any way forecastable. However, the diagram below might help:

 

If the break-up occurs because a few peripheral currencies exit the euro, but the “single” currency otherwise remains intact, then those investors who hold their funds within the German financial system could expect to see these “euro” holdings revalued against outside currencies like the dollar (Route 1 in the diagram). Meanwhile, those who previously held euros in countries like Italy would probably find that they now hold new lira instead, which would rapidly be devalued against all other currencies, including the euro.

Another possibility, however, is that Germany and a few other countries choose to depart from the eurozone because they fear that inflation is becoming an unacceptable threat within the zone (Route 2). It is a stretch to imagine that this sub-group could, or would want to, retain the title “euro” for their new currency. More likely, they would want to call it the new mark, or something similar.

My own guess is that the remaining members of the current eurozone would then fall apart, and reintroduce their own national currencies (Route 2a). In that event, the euro would cease to exist, and would no longer trade on the foreign exchange market, leaving investors to experience gains and losses according to where (geographically) they were holding their funds. A less likely alternative (Route 2b) would be for the non-German group to retain the euro as their currency, in which case a smaller version of the euro would remain intact, but would be devalued against the dollar and the new mark.

The upshot of this is that investors holding euros in f/x or other contracts could see the value of their holdings rise, fall or become subject to prolonged legal uncertainty, depending on exactly how the break-up occurred. That represents an awful lot of uncertainty for any investor who takes the break-up as even a remote possibility.

There would be some very random transfers of wealth as a result of the exchange rate adjustments which would occur in each of these cases. Those entities holding net assets in foreign currencies would gain from devaluation, and vice versa. And there would be rapid adjustments of competitiveness in the goods and labour markets of the old eurozone. In all cases, the currency used in Germany, whether or not still called “the euro”, would be sharply revalued.

Some might argue that the break-up of the euro might achieve the inevitable changes in competitiveness more quickly and more painlessly than the alternative of making the same adjustments far more slowly within the eurozone. After all, many other currency regimes have broken up, and in general the sky has not fallen in.

However, a disorderly break-up of the euro could be much worse. There are three reasons for this:

First, the resulting exchange rate adjustments would be large and completely unexpected, and few economic entities would be hedged against them. This would mean that the wealth and income transfers would be substantial and chaotic. It is likely that the losers would cut their spending by more than the gainers would increase their spending, so aggregate demand could plummet.

Second, among the main losers would be the banks in the revaluing countries, including Germany and probably France, which would see the value of their foreign assets, eg Italian bonds, decline sharply. Such a banking shock would not be exactly welcome in the present circumstances.

Third, if the euro were to disappear altogether, the extra complication of how to handle all the contracts denominated in euros would be a legal morass which would take many years to resolve, and in the meantime the financing of international trade could collapse for an unknown period of time. (The extraordinary legal complications are discussed here.)

Once investors start to look over this precipice in earnest, the resulting stampede out of all euro-denominated assets could become self-fulfilling. And any disorderly break-up of the euro would, at the very least, result in a period of deep European recession, before the eventual economic recovery could begin.

So serious are the risks that Germany and France are today reported to be contemplating urgent steps to save the euro by adopting earlier fiscal union, and by increasing financial support for peripheral bond markets (Route 3). About time, too.

To quote Neil Sedaka:

I beg of you don’t say goodbye

Can’t we give our love another try

Come on baby let’s start anew

‘Cause breaking up is hard to do