Friday, 17 August 2012

The Effects of a Euro Collapse

Some believe that the destruction of the Eurozone, and as a consequence the collapse of the common currency, is eminent. Many actually look at this favorably as they believe that such a result would be beneficial to the world. I have read articles stating "why doesn't the Euro collapse to get over with this situation? We will deal with the consequences and then be better off". The problem is no one seems to understand what these consequences are. 

The following is an excerpt from a Financial Times article in 2011 (article can be found here):
"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."
Does this sound bad enough? The article states that a Greek exit could be manageable. It could be, only if the ECB decides to bail-out the EU countries which would be affected by that exit (That would be hmm... almost every country in the EU, even Germany). If the ECB decides that it would help the countries which would face disaster after a Grexit then why not help Greece directly and avoid such an outcome? The outcome of an Italian exit would be even worse given that it is the 8th largest economy in the world. You may only imagine what would happen if Germany were to exit.

The aftermath of an exit would occur not only to the Union but to the exiting country as well. For example, a Greek exit would mean that prices and wages in the country would fall rapidly, gaining a short-run competitive advantage which would be lost after inflationary powers settle on the country. As a result, the country would be poor, uncompetitive and with the additional disadvantage that no one would dare lend it because it that had just exited the EU. If Germany exits then the new German currency would suffer such an up-rise which would make all German products uncompetitive, leading the now booming German exports to a downward spiral.
In another article, a euro collapse is called as the "mother of all financial disaster". Robert Zoellick, the former president of the World Bank has stated that Europe may have a Lehman moment. (Just like the Lehman Brothers collapse in 2008, which triggered the worst recession in the world since the 1930's).
The worst part of all is that most of the consequences which may occur under a Euro collapse are still unknown. Germany is thought to be the state with the most sound economy in the EU now. However, German investors hold 550bn euros of sovereign bonds outside of Germany. What would happen if the euro collapsed? Most likely they would lose it all and the German government would have to bail them out. One may only imagine how many EU bonds are in the hands of non-European banks and other investors.

My simple conclusion agrees with this LSE article: It is better to do everything to save the euro than to let it fall apart.

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