What Would Happen if the Euro Collapses?

Readers Question: What would happen if the Euro collapses?

The most likely scenario is that countries will leave one by one. A country would default on its debt and decide best option is to leave and create a new currency. The first country to leave would be Greece. Greece would be damaging, but if Greece was followed by bigger economies like Spain, Italy and Portugal it could be devastating. There would probably remain a small nucleus of countries around Germany in North Europe who manage to retain a common currency – Germany, Netherlands, Belgium, Luxemburg – possibly France.

Likely Impact of Euro Break Up

Capital Flows from Departing Countries.

If a country left, their new currency would devalue by 20-30%. Therefore, if you have savings in Italy / Greece, you could see a 20-30% devaluation in its value. Therefore, investors will seek to remove their savings from Italian banks and sell their Italian bonds. They would then put their money in the ‘safer’ northern block. Due to financial globalisation, it is relatively easy for people to quickly to withdraw their money. It would be much more damaging than say the run on Lehman Brothers. Therefore, countries leaving the Euro would see a potentially damaging level of capital flows. Outward capital flows would have a bad impact on confidence. It would limit Italian banks ability to lend and would cause lower economic growth.

European Credit Crunch

If there was a run on Italian banks, there would be knock on effects for other European banks and financial institutions who have stakes in Italian banks. They would lose money in the bank run, and there would be a fall in confidence. It would lead to a European wide decline in Bank Lending.

Economic Growth

A credit crunch would lead to lower economic growth in Europe. It is hard to predict, but the uncertainty and scale of bank flows could lead to a significant drop in European output. This would be socially very damaging given the scale of unemployment already in existence in Europe.

How Will the UK be Affected?

A Euro break up is predicted to cause the UK economy to fall by 2-4%. Given the prolonged recession and current high unemployment, this would be particularly unpalatable. The main reason for the fall in UK output would be

  • Fall in exports to Europe
  • UK financial sector hit by European credit crunch
  • Loss of financial and consumer confidence as a result of the break-up

The UK could also see an appreciation in the Pound as investors seek alternatives to the Euro.

How Will Greater Germany be Affected?

If southern Eurozone economies leave the Euro, it will lead to a transfer of capital into Germany as investors seek a safe haven away from devaluing southern Europe. This could lead to an appreciation in the remainder of the Euro, although if markets fear even the future of Germany, they may seek other currencies. It also depends on the extent of German losses from Italian and Spanish banks. However, Germany would be badly affected by a deep European recession because they rely on exports to other European economies.

What Would the Benefits of A Euro Collapse Be?

Many commentators focus on the short-term costs of a Euro break up. However, another way of looking at a Euro breakup is that it needs to break up or at least be fundamentally changed.

The fundamental uncompetitiveness of southern European economies is a disaster for their long term economy.  (See: competitiveness of Europe) With current account deficits of close to 10% of GDP, their uncompetitiveness is leading to very high unemployment, very low economic growth and rising debt to GDP ratios. In the Euro, they fear years of austerity, low growth and high unemployment. Leaving the Euro enables their currency to reach a level which reflects their underlying competitiveness. It means that out of the Euro, they will have more flexibility and will be able to at least target economic growth rather than the overwhelming insistence on budget cuts. From a social perspective which is worse?

  • 10 years of spending cuts, lower growth with political over-sight from Germany or a devaluation and temporary capital flight?

The Euro may scrape through the next few years, but even if countries do survive, the fundamental problems will not be solved. There is still the inevitability that countries will have diverging competitiveness and the problems this brings in a single currency. Whilst the Euro survives in the current form, there will always be this risk that countries face negative growth, rising debt, high unemployment and no real viable policy measures to overcome them.

This will not be solved by any fiscal stability pact which limits government borrowing.

Further Reading

1 thought on “What Would Happen if the Euro Collapses?”

  1. Indeed I read there is already evidence in Greece of depositors moving their Euro’s to banks outside Greece save they end up with devalued drachma’s. However the end of the Euro may not necessarily mean the end of the EU – just 17 out of the 27 members have adopted the Euro.

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