Many people keep asking whether the Euro can really cease to exist. Although everything is possible, we try to show ad absurdum why the demise of the Common Currency is at least unlikely.
Let us first say that, given very bad crisis management from the French, but chiefly German side the cost of keeping the Euro together has risen , obviously exponentially (How Chancellor Merkel with her PhD in physics could not foresee it remains a mystery). Because of previous choices risks have been reintroduced within the monetary union. First credit risk (it is not obvious anymore that a Euro country cannot default: see previous post), then currency risk. The latter point requires an explanation. When France and Germany, in a press conference following one of their many (too many?) bilateral meetings, declared that staying in the Euro was for Greece to decide, they implicitly admitted the possibility to opt (or be forced) out. Markets, logically, started pricing the possibility of an exit, measured as the percentage of devaluation in case of exit multiplied by the probability that the event occurs. Since the possible devaluation would be according to many, around 30-40%, even a not very high likelihood of exit, say 10%, implies a 3-4% premium: a huge number.
All spreads have since started rising, In particular, short-term spreads have risen more than long-term ones, That means it costs more to countries to finance themselves at 2 years than at 10. Although it cannot be proved, it cannot be excluded that the increased cost is due to the possible exchange rate of a new (old) currency. This on one hand is more likely to happen in the short than in the long term (if the Euro survives the next 2 years, it is probable that it will survive another 8). On the other hand, in any case, the effect would mainly be short term. The time would be similar to the duration of government debt, which in the Eurozone periphery is just around 2 to 3 years.
Given all the above, the crisis of the Euro is resembling more and more a crisis of emerging countries that pegged their currency to a stronger one. There are several examples of such crises in South America in the past decades. In these cases, mostly currencies were pegged to the US dollar. There are obviously differences between these cases and the Euro, in that in South America currencies have remained separated (at all times a dollar was a dollar and a peso a peso). Risks involved, though, were similar, i.e. credit and currency risk for the weaker Country.
Looking at the previously mentioned examples, let us see how a break-up would occur. Before someone gets scared: this scenario is by far the least probable; reading until the end it will be clear why.
People wake up one morning, almost invariably a Sunday (banks are closed) to learn that from today 1 Euro has become X new Liras, Dracmas etc. Most people will have worked out this but failed to consider the consequences, inevitable unless other measures are put in place at the same time. On Monday morning there are queues in front of bank branches as everyone wants to take money out and/or exchange it for another currency (this can also occur on bank internet severs).
In fact people would think, and with good reason, that the new (old) currency would quickly lose value against the other stronger currencies. This would very probably mean the collapse of the banking system even before debt in stronger currency could break it. The only way to avoid collapse would be to announce at the same time of the introduction of the new (old) currency limits on withdrawals and, above all, controls on capital and people at the borders. Such limits would be against the basic treaties of the European Union. A collapse of the Euro would therefore be inevitably linked to implosion, or at least suspension with possible strong downsizing, of the Union itself. All the above measures could not probably save the banks, which would need massive capital injections form the State.
Before thinking this would be desirable, please consider that consequences, in particular for exporting Countries such as Italy, would be dire. The Country with most to lose from a failure if the Euro is of course Germany, the strongest intra Eurozone exporter, which would be hit by a double whammy of a drastic revaluation of its currency and the new limits to free movement of people and trade. This already explains why a Euro collapse is improbable: it would cost Germany much more than keeping it going (see ‘Germany and the apprentice sorcerer).
Consequences of a break-up, however, would not be limited to those just described. Those on companies would be even greater. In fact, many commercial transactions even of small firms are now international. For example, a Spanish firm having to pay a French supplier in Euros would see its debt increase because of the fall of the Peseta against the Franc. Interconnections are such and so many that a chain of default would be probable. Obviously this would lead to increased unemployment all over Europe. In the end the only way to avoid chain defaults would be for Countries leaving the Euro to print money. That would start an inflationary spiral which would end up not being able to contain failures but would bring even greater value destruction.
Given all the above it is therefore very improbable that a Euro break-up be allowed, not least because it would disadvantage most just the Country which now opposes drastic monetary measures, i.e. Germany.
At this point one could ask whether German politicians know all this. The answer is they probably do, but perhaps they think they can hold on until the elections in 2012 before enacting the inevitable. We doubt they will have this luxury, as the exponential function (yes, still that) is already weighing heavily on events.
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