Here's What Will Happen if the Euro Fails

In 2015, the European Union (EU) was in a state of flux. There were major banking troubles at Deutsche Bank AG (NYSE: DB), Credit Suisse Group AG (NYSE: CS) and virtually every Italian financial institution. Greece was suffering economically, and several other countries seemed to be destined for the same. In 2016, the United Kingdom voted to leave the EU with the Brexit vote, and the European Central Bank (ECB) introduced negative interest rates in a desperate attempt to spur growth. But in 2017, the tide was turning.

The eurozone enjoyed its best year in 2017 in a decade showing that it was finally emerging from the debt crisis that threatened the euro. According to Eurostat, the European Union's statistics agency, the eurozone expanded by 2.5% in 2017, which surpassed the growth of the United States at 2.3%. Greece would emerge from its bailout status by mid-2018, and other countries that suffered after the great recession of 2008 were stronger and seeing less unemployment. The euro appreciated against the dollar although this makes exports from the zone less competitive globally [1]. While the eurozone was finally on an economic upswing, what would happen if another recession were to occur and the euro were to collapse?

A collapsed euro would likely compromise the so-called “Schengen Area,” named after the 1995 Schengen Agreement. Under this agreement, 26 separate European countries agreed to allow free movement of people, goods, services and capital within the borders of the eurozone. Not every member of the EU is also a member of Schengen, and not every participant in Schengen is part of the EU, but a collapse of the euro would nonetheless affect countries inside and outside of the region.

Economically, it is possible to have competing currencies in the same economic zone. There is nothing preventing Germans or Italians from trading in both German deutsche marks and Italian lira, for example. That scenario only seems unlikely because an end to the euro would increase pressure to dissolve the entire EU experiment.

If Schengen were to fall, countries inside the eurozone would need to implement border controls, checkpoints and other internal regulations previously eliminated in the Schengen Agreement. The costs of this would spill over into private businesses, particularly those relying on continental transportation or tourism.

To the extent that import quotas or tariffs are implemented by various member nations, and to the extent that those measures are reciprocated elsewhere, there would be a corresponding decline in international trade and economic growth. A collapse of the euro would affect more countries than those in Europe although in uncertain ways. Other regions, particularly major trading partners in North America and Asia, would face financial and possibly political consequences.

Many of the supposed economic benefits inside the EU do not transfer to external trading partners. The freedoms of labor and capital do not extend to the United States or China, for example, unless foreign consumers and producers gain access to a member country. This makes it difficult to predict potential fallout since it is possible that even stronger pro-growth policies could replace the bureaucratic super-state seated in Brussels. On the other hand, increased economic isolationism from nationalist movements threatens international businesses and financial markets.

In the short term, markets would likely react negatively to added uncertainty. The EU is a known commodity, even if imperfect, and markets like predictability. In the longer term, however, the markets could benefit from a once-again growing Europe. Between 2010 and 2015, Europe lagged significantly behind the Americas, Africa, Asia and the Pacific regions in real gross domestic product (GDP) growth. If a post-euro world returns continental Europe to competitive economic growth, it is very likely that the global economy will benefit.

The official term for leaving the euro and installing an old currency is called “redenomination.” Such a conversion would almost certainly be less complicated than coordinating the adoption of the euro in 2002, but investors should still be wary of uncertainty.

Redenomination would entail two broad changes. The first is the official adoption of a new currency within one nation’s boundaries. This means adjusting present wages, prices and other values to the new money in an approximately proportionate basis. Second, the international value of the currency would need to be priced into foreign exchange (forex) markets. This is based on many factors, including the productive capacity of each national government and the relative risk of a devalued currency.

It is likely that many indebted countries with lots of foreign creditors, such as Greece, would try to redenominate to reduce their real repayment burden. One way to accomplish this is to redenominate and immediately begin strong inflation to reduce the purchasing power of the repaid debt. Economists sometimes refer to this as “instant internal devaluation.” The downside to such a policy is that it creates havoc in the devalued country’s economy, since bank accounts, pensions, wages and asset values suffer.

Close historical parallels can be found after the collapse of the Austro-Hungarian Empire, which stood between 1867 and 1918. After the empire fell apart, many member countries hoped to retain the Austro-Hungarian krone as currency. Unfortunately, several irresponsible governments used highly expansionary monetary policies to pay off the high debts from World War II, triggering hyperinflation in Austria by the early 1920s. Slovenia, Hungary and others experienced much of the same. By 1930, each former member nation had to use a new currency often backed by gold or silver.

If the only change was a replacement of the euro by competing national currencies, the abolition of the euro would only create real long-term changes in monetary policy. The eurozone was originally sold, in part, by the concept of creating a European counterpart to the U.S. Federal Reserve. Eliminating the euro would decentralize monetary authority back to the member nations; for example, a German central bank would control interest rates and the money supply in Germany while a Portuguese central bank would control them in Portugal.

Banks could recapitalize in their national currencies although they would likely have to keep more active foreign exchange balances for regional trade and reconciliation. The various exchange rates would change the relative values of some assets held internationally, and the workers in less-inflationary European job markets would see a relative income boost compared to European governments with loose monetary policy. For example, it is likely that workers in highly productive Germany would have an easier time affording goods and services produced in less-productive Slovenia.

However, it is unlikely that other economic policies would remain unchanged if the euro failed. Even if the EU technically survived, other restrictions could be implemented on immigration or trade. Pro-euro parties would likely suffer political consequences, allowing for nationalistic parties to gain influence and to implement new fiscal policies. If Schengen also failed, the economic consequences could be extremely disruptive, even if only in the short term.

[1] https://www.cnbc.com/2018/01/30/euro-zone-economy-enjoys-its-best-year-i...