What happens if the euro collapses?

By James Pethokoukis


That is the question Citigroup tries to answer in a new note. The bank’s forecast is global depression and possibly war. But lawyers would do OK. More from Citi economist Willem Buiter (bold for emphaisis):

1. A break-up of the Euro Area would be rather like the movie ‘War of the Roses’ version of a divorce: disruptive, destructive and without any winners. A break-up of the 17-member state Euro Area, 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 DM zone and around 10 national currencies would create financial and economic pandemonium. It would not be a planned, orderly, gradual unwinding of existing political, economic and legal commitments and obligations.

2. Exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally weak and uncompetitive 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. Even if the likelihood of an eventual exit or break-up were to be assessed accurately by the markets – something for which there is preciously little evidence – the timing of any exit or break-up is bound to come as an unexpected and deeply disruptive event.

3. A disorderly sovereign default and EA exit by Greece alone is manageable. Greece accounts for only 2.2 percent of EA GDP and 4 percent of EA public debt. However, a disorderly sovereign default and EA exit by Italy would bring down much of the European banking sector. Disorderly sovereign defaults and EA exits by all five periphery states – an event to which I attach a probability of no more than 5 percent, would drag down not just the European banking system, but the north Atlantic financial system and the internationally exposed parts of the rest of the global banking system as well. The resulting global financial crisis would trigger a global depression that would last for years, with GDP falling by more than 10 percent and unemployment in the West reaching 20 percent or more. Emerging markets would be dragged down too. Even the limited financial turmoil emanating from the Euro Area thus far has contributed to the marked slowdown of growth in the world’s three most important emerging markets – China, Brazil and India.

 4. Exit by Germany and the other fiscally and competitively strong countries would be possibly even more disruptive. This might occur if there were 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 percent. Following the exit, Germany and the other core EA member states (perhaps excluding France) would introduce the new DM. The sovereigns in the periphery would default. The new DM would appreciate sharply. Financial institutions in the new DM area would have to be bailed out because of losses from exposure to the old periphery and the soft core. As nothing holds the remaining EA countries together, the rump-EA splits into perhaps 11 national currencies. The legal meaning and validity of all euro-denominated contracts and instruments is up for grabs. Everyone, except lawyers specialising in the Lex Monetae, becomes much poorer as business is put on hold while the mills of the courts grind slowly.

5. Even if the break-up of the EA does not destroy the EU completely and does not represent a prelude to a return to the intra-European national and regional hostilities, including civil wars and wars, that were the bread and butter of European history between the fall of the Roman empire and the gradual emergence of the European Union from the ashes of two made-in-Europe world wars, the case for keeping the Euro Area show on the road would seem to be a strong one: financially, economically, and politically, including geopolitically.

http://blog.american.com/2011/12/what-happens-if-the-euro-collapses/