Disbanding The Euro - A Worst-Case Scenario

By Stephen D. Simpson, CFA | June 04, 2010 AAA

Only time will tell if we are past the worst of the debt crisis in Europe, or simply enjoying a calm amidst the storm. In either case, the crisis in Greece and the fears of its spread into Spain, Italy and Portugal have led many financial analysts and commentators to seriously consider what had once been mostly the domain of crackpots - the notion that the euro could collapse and vanish altogether.
This is no small matter. Of the 10 largest economies in the world, four use the euro as their currency. Roughly 330 million Europeans use the euro every day, while nearly 200 million people use currencies that are pegged to the euro (many of them in Africa). It is also the second most-used currency as a reserve currency, with roughly one-quarter of the world's reserves held in euros.

IN PICTURES: 7 Currency Blunders You Could Cash In On

Step 1 - Panic
The immediate consequence of the collapse of the euro would most likely be a great deal of volatility and chaos. Given that market participants generally loath chaos, it would probably mean some ugly days for global stock markets and lower interest rates in the U.S. as investors flea into U.S. government bonds. In a perhaps ironic twist, though, it would not be entirely shocking if some markets rose on the news - investors in Britain, Germany and countries like Denmark and Sweden may see the fall of the euro as beneficial to their countries.

Step 2 - Pay More, Get the Same
With the euro disappearing, there would be an increase in the costs of doing business with and within Europe. Banks do not exchange money for free, and so companies would face higher transaction costs as the number of their operating currencies would increase. In other words, companies would not necessarily have any expectation of selling more product to the current eurozone (in fact, there could be lower demand), and those sales would now be more expensive.

In addition, risk has a price and the risk of multiple volatile exchange rates would impose an economic cost as well. It is difficult to price the cost of exchange rate volatility, but economists have theorized over the years that it could be a figure in the range of 1-5%, expressed both as a percentage of assets or revenue involved and national growth rates.

The liquidity of financial instruments like stocks and bonds that are currently denominated in euros would also likely decline. Here too would be additional costs, as lower liquidity almost always means higher trading costs. (To learn more, check out What Is International Trade?)

Step 3 - Less Growth
The disappearance of the euro would likely support the value of the dollar, at least on a short to medium-term basis. While some countries that currently use the euro as a reserve currency would likely be happy to use the German deutschemark in its place (and perhaps the French franc as well), it most likely would not be on a one-for-one basis. Consequently, more reserves would be shifted to other currencies and the dollar would be the most logical beneficiary. Though that may sound good now, it would be bad for exporters and it would likely lead our politicians to delay even further in implementing necessary financial reforms here at home.

Longer term, growth rates across Europe would likely decline. Many of the euro's member countries currently enjoy lower interest rates than they would have otherwise. In fact, this ready access to relatively cheap debt is a large part of what got countries like Greece and Spain into this mess in the first place. Evaluated solely on their merits, many of these countries would see significant, if not punishing, increases in the cost of their debt. What those higher rates would take out of economic growth would likely offset (if not surpass) the gains that would come from the initially lower currency exchange rates.

The disappearance of the euro and the reemergence of individual currencies would also raise the specter of competitive devaluations and depreciation (depending upon the individual currencies policies set up in the wake of the euro). This policy, often referred to as "beggar thy neighbor", basically involves making your imports more expensive and your exports cheaper. It works well enough until your neighbors catch on and try it on you - then you all realize that there is nobody left to buy your exports and the game stops working.

The Bottom Line
Although countries like Germany, France and The Netherlands want to support the euro, there is a limit to this patience, particularly in Germany. While Germany has certainly benefited from the euro and would see exports drop in its absence (its current customers would not be able to afford as much), the country should not pay more to keep the euro than it would lose from going back to the D-mark.

Should this all occur, there would be a painful period of adjustment and then our economic and investment lives would go on from there. Would this catapult countries like Brazil into new prominence or give a leg up to nations like Turkey? Only time will tell, but investors should keep a wary eye on the Continent - if your investment philosophy is predicated on stable growth and low interest rates throughout Western Europe, you may need to revise that outlook for some time to come. (To learn more, see What The Falling Euro Means For You.)

Catch up on the latest financial news in Water Cooler Finance: Buffett Speaks Up, AIG Deal Collapses.

You May Also Like

Related Articles
  1. Economics

    Profiting From China's Breakout: The ...

  2. Economics

    How Bitcoin Is Helping Ordinary People ...

  3. Economics

    Where is Bitcoin Regulated?

  4. Economics

    Who Uses Libor Data And Why?

  5. With a long list of risks, losses associated with foreign exchange trading may be greater than initially expected. Here are the top 5 forex risks to avoid.
    Economics

    Top 5 Forex Risks Traders Should Consider

Trading Center