Economists Predict Currency Breakup

The next question to ask, and it’s a big one, is how will the Euro collapse?  The creators of the Euro zone, in their wisdom, didn’t create an exit path should a country need to leave the Euro (a Titanic mistake).  And it would seem that there is no natural exit path.  Let’s look at a hopefully hypothetical scenarios for Greece.  Suppose that Greece defaults, or is about to default, and their Eurozone bedfellows decide they will no longer foot the bill for the Greek debt.  Greece is then effectively pushed out of the Euro by the other Eurozone countries.  What does the Greek government do?  No doubt it would start to print money – let’s say for nostalgic reasons they start to print Drachmas.  The first problem would be the legitimacy of the new currency.  What is it backed by?  Clearly there is little if anything backing it.  Which leads to the second problem – the exchange rate.  What would be the exchange rate between Euros and Drachmas?  All of the Greek savings are in Euros and who would want a currency which, on day one, is clearly weaker than the Euro?  Nobody. At this point in the logical progression the size of the problem becomes crystal clear.  Nobody will want a weak currency and the only way it can be introduced is by force.  The Greek government would need to impose draconian measures forcibly converting citizens’ savings into the new currency.  The riots we have seen on the streets of Athens will be nothing compared to the civil unrest which would undoubtedly follow.  The new currency would fall in value, the debt will remain in Euros (i.e. increase in value), the price of foreign good will increase (i.e. inflation) and real widespread poverty will ensue.

Is there an alternative?  First, this scenario is real and the Eurozone countries may recognize the potential contagious impact on their own economies.  This may lead them to the conclusion that no matter how bitter the pill they are better off sticking together.  In this scenario Germany would have to continue to back its weaker neighbors.  The Euro would fall in value against the US dollar and Yen and the misery would be spread across the Euro zone.  As grim as it sound this scenario is quite possible.  European integration is primarily a political project and there are many politicians who will fight to the end to keep the Euro and the European dream alive.

The final scenario would be for Germany to leave the Euro.  There would still be problems establishing the legitimacy of the new currency but it is likely that this could be navigated.  Fundamentally, the new Deutsche Mark would be in demand and the German government would not need to impose any form of enforced currency conversion.  Clearly the Euro without Germany would be weaker still and would surely fall in value. No doubt Germany would be blamed for the problems which would follow (higher inflation) for the countries still in the Euro.  One key point would be the debt of countries still in the Euro (such as Greece) would still be in Euros – so the debt will diminish as the currency devalues.

If I had to guess, I’d say the last scenario is the most likely.  It’s not a bright outlook but seems to be the lesser of the evils.

Now you may say the Greek government could simply start to print Drachmas and declare the Euro as no longer legal tender.  The problem is all the gold and currency reserves are held in Frankfurt and controlled by the European Central bank.  The Greek government would need to “ask” the ECB for its fair share.  But what is a fair share for a country that is basically bankrupt (hint: it’s close to zero).

This means there would be nothing backing the new Drachma currency.  The tension created by no exit path is tremendous and could ultimately lead to the explosion of the Euro.  The alternative is for wealthier countries such as Germany and France to foot the bill for Greece’s miss-management.  A measure that is certainly unpopular and possibly illegal.  I would certainly not recommend investing any money in the Euro currency as its value will be hammered as it negotiates though these choppy waters ahead.

I predict less than parity to the US dollar within two years i.e. €1 = $0.9.

Back in 2000 the UK was debating whether to ditch the pound and adopt the Euro as its currency.  Broadly speaking, the UK Conservatives were in favor of keeping the pound while Labour and the Lib Dems were leaning towards adopting the Euro.  However the No-Euro campaign was launched by a several prominent businessmen to oppose the switch to the Euro.  This was, in my opinion, an extremely well run campaign that in agreement with the general skepticism of the British people.  In 2002 the No-Euro camp effectively won and the Labour government declared that there will not switch from the UK pound to the Euro in the foreseeable future.

So let’s review each of the “Ten Reasons the Euro is BAD”.  The first one is, “One Interest Rate Cannot be Right for Everyone”.   Since the Euro is controlled by one entity (the European Central Bank), it must have one interest rate.  In general the ECB has set the interest rate to make sure the growth of the larger countries within the Euro zone (i.e. Germany and France), which have over the last ten years required low interest rates.  The smaller, and inherently weaker, economies such as Ireland, Portugal and Greece seemed to benefit from these low interest rates.  Effectively the ECB backed their debt fueled boom that ran from 2002 to 2008.  Then came the downturn – the shock to the system.  Money became tight and now, in 2010, it’s payback time.  Greece is now grappling with an out of control budget deficit of 12% of GDP – way above the 2% ceiling “demanded” by the ECB.  What now?  Well since the ECB effectively backed Greece’s debt it needs to pony-up the money to ensure Greece doesn’t default .  But where will the ECB get the money from?  It has a couple of choices – none of which are attractive.

The first option would be for the ECB to just let Greece default.  This would be nothing short of a disaster.  Effectively Greece would go bankrupt and government workers would not get paid, leading to riots in the streets of Athens.  It is unlikely the Euro would survive such a course of action.

The second option would be for the ECB to go to the larger economies and ask them to assist Greece at their time of need.  This isn’t going to happen.  The Germans and French are also struggling though the financial crisis and don’t have any spare cash to lend their struggling European neighbors.  The key here is the German government is still only elected by the German people, so it will act in the best interests of the Germany people with zero consideration for Greece.

It’s final option is to power up the printing presses and print more money.  This will devalue the Euros already in circulation and cause general inflation across the Euro zone.  Since the main aim of the ECB is to manage the Euro and ensure its stability this option would warrant a big black mark but looking at its other options this is probably the most likely.  It’s the least visible and spreads the misery evenly across the Euro zone.

It’s interesting to also consider what would have happened if Greece had kept the Drachma.  It’s likely the Greek economy would not have been able to warrant such low interest rates so the debt fueled bubble wouldn’t have been so big when it popped.  Also if Greece still found itself with a budget deficit it could either raise interest rates to attract more investment or devalue the currency to stimulate exports.  Neither option is available as it has given up control of its currency to the ECB.

So Greece is a real example of why one interest rate is not practical across so many diverse economies.  So we can conclude that one interest rate across all the Euro zone is still a bad idea!