How (and not when) will the Euro Collapse?

The Euro in under immense stress and the crisis in Greece is only the start.  Spain, Portugal and Ireland will no doubt follow.  The key problem is clearly government spending.  It’s far too high and is racking up debt at an unsustainable rate.  The day of reckoning is fast approaching.  This is becoming clear to commentators and the first forecasts of the Euro’s collapse are starting to be reported – such as here:

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.

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