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The End of the Euro: A Survivor’s Guide

In every economic crisis there comes a moment of clarity.  In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone.  Economic chaos awaits them.

To understand why, first strip away your illusions.  Europe’s crisis to date is a series of supposedly “decisive” turning points that each turned out to be just another step down a steep hill.  Greece’s upcoming election on June 17 is another such moment.  While the so-called “pro-bailout” forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens.  It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers – either because they can’t pay or because they expect soon to be able to pay in cheap drachma.

The troika of the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF) has proved unable to restore the prospect of recovery in Greece, and any new lending program would run into the same difficulties.  In apparent frustration, the head of the IMF, Christine Lagarde, remarked last week, “As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time.”

Ms. Lagarde’s empathy is wearing thin and this is unfortunate – particularly as the Greek failure mostly demonstrates how wrong a single currency is for Europe.  The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange “internal devaluations” (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.

Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural.  With IMF leaders, EC officials, and financial journalists floating the idea of a “Greek exit” from the euro, who can now invest in or sign long-term contracts in Greece?  Greece’s economy can only get worse.

Some European politicians are now telling us that an orderly exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves.  They are wrong.  Greece’s exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone.

During the next stage of the crisis, Europe’s electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive.  If Greece quits the euro later this year, its government will default on approximately 300 billion euros of external public debt, including roughly 187 billion euros owed to the IMF and European Financial Stability Facility (EFSF).

More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone).  This includes 110 billion euros provided automatically to Greece through the Target2 payments system – which handles settlements between central banks for countries using the euro.   As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail.  This role is taken on by other euro area central banks, which have quietly leant large funds, with the balances reported in the Target2 account.  The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies.  But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data).  This amounts to over 200 percent of the (broadly defined) capital of the euro system.  No responsible bank would claim these sums are minor risks to its capital or to taxpayers.  These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros.  With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.

Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that – to avoid a greater calamity – all remaining member nations need to be provided with unlimited funding for at least 18 months.  Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.

We agree:  Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market.  The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere – so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?

The most likely scenario is that the ECB will reluctantly and haltingly provide funds to other nations – an on-again, off-again pattern of support — and that simply won’t be enough to stabilize the situation.  Having seen the destruction of a Greek exit, and knowing that both the ECB and German taxpayers will not tolerate unlimited additional losses, investors and depositors will respond by fleeing banks in other peripheral countries and holding off on investment and spending.

Capital flight could last for months, leaving banks in the periphery short of liquidity and forcing them to contract credit – pushing their economies into deeper recessions and their voters towards anger.  Even as the ECB refuses to provide large amounts of visible funding, the automatic mechanics of Europe’s payment system will mean the capital flight from Spain and Italy to German banks is transformed into larger and larger de facto loans by the Bundesbank to Banca d’Italia and Banco de Espana– essentially to the Italian and Spanish states.  German taxpayers will begin to see through this scheme and become afraid of further losses.

The end of the euro system looks like this.  The periphery suffers ever deeper recessions — failing to meet targets set by the troika — and their public debt burdens will become more obviously unaffordable. The euro falls significantly against other currencies, but not in a manner that makes Europe more attractive as a place for investment.

Instead, there will be recognition that the ECB has lost control of monetary policy, is being forced to create credits to finance capital flight and prop up troubled sovereigns — and that those credits may not get repaid in full.  The world will no longer think of the euro as a safe currency; rather investors will shun bonds from the whole region, and even Germany may have trouble issuing debt at reasonable interest rates.  Finally, German taxpayers will be suffering unacceptable inflation and an apparently uncontrollable looming bill to bail out their euro partners.

The simplest solution will be for Germany itself to leave the euro, forcing other nations to scramble and follow suit.  Germany’s guilt over past conflicts and a fear of losing the benefits from 60 years of European integration will no doubt postpone the inevitable.  But here’s the problem with postponing the inevitable – when the dam finally breaks, the consequences will be that much more devastating since the debts will be larger and the antagonism will be more intense.

A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008.   In fall 2008 the decision was whether or how governments should provide a back-stop to big banks and the creditors to those banks.  Now some European governments face insolvency themselves.  The European economy accounts for almost 1/3 of world GDP.  Total euro sovereign debt outstanding comprises about $11 trillion, of which at least $4 trillion must be regarded as a near term risk for restructuring.

Europe’s rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia.  Who can be confident that our global megabanks are truly ready to withstand the likely losses?  It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives.  The potential for political turmoil and human hardship is staggering.

For the last three years Europe’s politicians have promised to “do whatever it takes” to save the euro.  It is now clear that this promise is beyond their capacity to keep – because it requires steps that are unacceptable to their electorates.  No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.

Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF’s leadership are already covering their tracks, implying that corruption and those “Greeks not paying taxes” caused it all to fail.  This is wrong:  the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also.  Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery.  We cannot blame corrupt Greek politicians for all that.

It is time for European and IMF officials, with support from the US and others, to work on how to dismantle the euro area.  While no dissolution will be truly orderly, there are means to reduce the chaos.  Many technical, legal, and financial market issues could be worked out in advance.  We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system.  Some nations will soon need foreign reserves to backstop their new currencies.  Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.

Unfortunately for all of us, our politicians refuse to go there – they hate to admit their mistakes and past incompetence, and in any case, the job of coordinating those seventeen discordant nations in the wind down of this currency regime is, perhaps, beyond reach.

Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualisation scheme, or any other bedtime story.  We are each on our own.

A version of this material appears also on the Huffington Post.

This post originally appeared at The Baseline Scenario and is posted with permission.

28 Responses to “The End of the Euro: A Survivor’s Guide”

TomMay 29th, 2012 at 1:24 pm

Interesting but I think you underestimate the capacity of the eurozone to muddle and dilute by using central bank refinancing to pay out on deposits that are backed by unrecoverable assets. That is really the eurozone's default response to crisis and it's hard to see how hard moneyers could get enough support at the ECB to stop it.

Cathryn MatagaMay 29th, 2012 at 8:27 pm

"It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering."

Great piece, though I don't see much delivery here on the 'survival guide' title. Wouldn't EURO death be a deflationary event? Is it time to go to cash, or is this the moment for, "gold, groceries, guns and guts?"

BillMay 29th, 2012 at 9:09 pm

I as well agree on the breakup of the Eurozone and the demise of the Euro. It seems that it will breakup into perhaps 2-3 domains of power, certainly north and south but then there are the periphery countries so probably 3 separate alliances. I see the forecast of this failure but there is no survival guide offered here in this. Other than the obvious, to short the euro and the eurozone which I have, and then to also own your own assets and not have debt!

ElzoradoMay 29th, 2012 at 9:10 pm

Interesting and logically persuasive argument, but I think that Greek default/exit may not have the contagious effect expected. Or if it does it will be contained to those countries better off out of it under the current yardsticks. The Euro–once shot of these nasty PITA — ( so to speak) may well arise as a stronger currency. I know this contrarian view flies in the face of the numbers. The fact is that the world needs –and is increasingly dependent on –a second reserve currency, and collectively, nations will overlook the obvious holes in the real world ( as they have done from the start). Barring problems in Spain and Italy prompting them to fundmenatlly re-structure, I think the Euro may muddle through progressive exits of the tiddlers and emerge stronger in a world where absolutes and past measures of credit-worthiness, debt, value no longer have any currency. Pardon the pun.

frankiethepunkMay 29th, 2012 at 9:43 pm

Don't waste your time and money with gold, groceries and guns. If you really believe that the Euro is going to self destruct (and the authors make a good case for it) then short the markets. Pick an instrument (S&P/Russel 2000/Euro) and go short.

Patrice AymeMay 29th, 2012 at 9:49 pm

It is not a colossal error of a single currency. That statement is sheer anti-European propaganda. The correct statement is: the collossal error of leaving the creation of the single European currency to private banksters and other financial pirates.

Clearly the USA Federal Reserve is a bank too strong to fail: after all it has the Pentagon as lender of last resort. The ECB is not quite there yet. But there is no choice will Hollande explain to Merkel. Surely Merkel does not want to be called Merkler?

frankiethepunkMay 29th, 2012 at 9:52 pm

Well, I must say the Eurozone Politicians capacity to dither is without equal. It really is their most impressive talent.

That said, I think the crux of the Eurozone's survival rests on two fundamental issues: the first is the German Taxpayer's forbearance to continue bailing out their Mediterranean cousins. They won't. The second issue is whether the 17 nations of the Eurozone are willing to give up political sovereignty and fiscal sovereignty to become "The United States of Europe". They won't.

The truth when everything falls apart and the Euro-zone comes to a grinding halt, they will look back wistfully and wish they had that decision to make again. Chances are when the
S%&T hits the fan they will be ready to join the devil in hell to escape the pain they about to unleash on themselves.

frankiethepunkMay 29th, 2012 at 9:58 pm

Don't bet on it. To paraphrase Earnest Hemingway: "How did the Euro go bankrupt?"

"Two ways. Gradually, then suddenly."

gAntonMay 29th, 2012 at 10:13 pm

I don't like pessimsts and pessimism, and I think that the largeness and depth of the EU problem set is due to the fact that there a so many, many pessimists in Germany and the Nordic EU nations. There are many optimists in Australia and New Zealand, and I think that the only hope of salvation of the EU is that they convince Australia (and perhaps New Zealand) ro join rhe EU.

barfMay 29th, 2012 at 10:24 pm

I agree with this comment as unlike the article "it has the added value of being true." The fact of the matter is the ONLY solution is to debauch the euro. The idea that "Germany can just leave" is PURE falsehood and nothing more than propaganda. Those like the authors who make such patently false claims are dupes for folks "who have already planned and executed accordingly." Pure garbage…i expect something other than that here. God help you if you are "credentialed" as they say. Now a more interesting question is whether the devaluation will be "orderly or disorderly." THAT is something that actually matters of course as it "could involve your son or daughter" as they say.

shermMay 30th, 2012 at 12:05 am

I don't know how this is going to turn out. However, I would add one recommendation to all the others: take away their guns. Of a certainty, the European nations will be at each other's throats after any of the likely scenarios runs its course. The moment to minimize the destruction is at hand. NATO: Secure Arms.

Cathryn MatagaMay 30th, 2012 at 12:43 am

Yeah, I'm not really a gold-bug, to be honest. Honestly, I'm not sure what I believe — but I think there is potential for chaos here. I am afraid to mess with currencies though — the Yen, at least, seems to defy logic. I wouldn't be surprised to see, you know, Europe collapsing and the EURO going up.

GuestMay 30th, 2012 at 1:23 am

Interesting, however an observation. Your whole premise is based on an inability to change. However, there is the possibility that countries, having few alternativess will change their economic structures encouraging bsuiness development, similar to what Germany enacted in the 90s. Italy and Spain have enacted changes in the past few months, albeit kicking and screaming, but nonetheless enacting the legilation. In that case, there is (again) the possibility of growing out of the problems they are in. Additionally, it is possible that countries will have to forfeit some of their powers to the EU. Of course that is a lot of ifs, however, this is certainly preferable to the alternatives. Nothing like looking into the gates of hell to encourage people to rethink their priorities.

Aegean1972May 30th, 2012 at 7:55 am

i agree with the article

in the years to come, most euro countries will be "everyone on their own".
back to their own currencies.

it ll be interesting to see what germany will do by then. they will be in the dillema :

do i wait till most of the periphery exits and keep the euro for 3-4 core countries of the same culture or do i exit the eurozone during the chaos, cut my losses and work on a strong duetche mark while the others will have a constantly depreciating euro in their hands?

StrangeMay 30th, 2012 at 9:44 am

Today, one could read in German newspapers that Merkel said the ESM is no EU project. That means the German parliament and federal states are not allowed to vote or intervene. Second, the ESM shall be allowed to give money to banks directly without any necessity of austerity or reforms. If she can make it this way the last fortress and defense of democracy will have been fallen. It is incredible what the 'elected' German government dares to do now. Every investor should be aware of the fact that he invest money in a dictatorship called EU from that moment.

MeredithMay 30th, 2012 at 10:57 am

Do I detect a NIMBY ism (Not In My Back Yard) attitude among the EU nations. At this point, ALL EU nations should stop acting like children, join hands and work out this problem that they OBVIOUSLY got themselves into. The only time we see any action, regardless of what the problem may be, is when the S%*T hits the fan, then everyone reacts, positively or negatively. But first, you have to admit there's a PROBLEM…Come on EU, I'm pulling for you because I love Europe, so please, "get your act together". Maybe you should consider dumping the Euro and reconsider an alternative. In the words of Dr. Martin Luther King, "free at last, free at last, thank GOD almighty, we're free at least" of the Euro.

rodeneugenMay 30th, 2012 at 5:11 pm

Peter Boone & Simon Johnson probably made a bet against the Euro and now they try to bring it to happened.

The German taxpayers have paid already to Greece, when they gave them loans to finance their wasteful standard of living. Now it is only the clean of of the mess that remained after the party.
The facts are;
- Greece GDP is about 240 milliard Euro.
- Greece debts after the last write offs are about 400 milliard Euro, mostly external.
- Greece annual current account deficit is about 30 milliard Euro + 20milliard for interest.
- All what IMF &ECB &Others are ready to do is to change the old loans for new ones, with prolonged expiration date and reduced interest rate.
There is no way they can pay for this.
Greece will never decide to leave the Euro zone,whoever will be elected, will have no mandate for it, but will have no money to continue on, not to speak about paying back debts. Will this destroy the European Union? Is the remaining Greece debt too big to fall? . Is 3% increase out of GDP of net debt in the Euro Zone so devastating? NO.

As to Greece, it will have after the new election an extreme left-right government , with no will to make any real decisions and will default and stay in the Euro Zone, but without Euros to pay government employed, the pensioners, etc. To overcome the problem, the new left-right government will issue bonds called Eurodrach, with securing delayed Euro payments for four years (the life expectancy of the left+right government). The Euros, will disappear from the markets, and be replaced by the Eurodrachs, its rate after wild fluctuations will stabilize on 1 Euro to 3 Eurodrachs. Slowly Greece economy will return to function. Finally after the new elections at 2017, a new central liberal-conservative-socialistic coalition government will be created, and will try to renegotiate its return to Eurozone, that it never officially left. Greece, IMF and ECB will agree new terms for restructuring its sovereign debt in which the Greece debts will be limited to sustainable level of 120% of its GDP, subject to its voluntary withdrawal from the Euro zone. By then the Greek GDP will be 120 milliard Euro and its new dept accordingly 144 milliard Euro.

I don't see why would this cause collapse of the Euro. Greece economy was unique from the beginning. It never had the political commitment to pay the bills. It is not the case of the other I.P.S.I.s

Matthew H.May 30th, 2012 at 9:09 pm

How can I profit from a European catastrophe? Is there an ETF that specifically shorts the Euro economy and will soar if the economy dives?

DiranMMay 31st, 2012 at 1:50 am

BS! You do not get at all Simon's crucial point, that these Euroweenie idiots keep doubling up and increasing the costs of Euro departure to a point where the risks to investors are so catastrophic that they have no choice but to flee the Eurozone. Euroweenies have made the EU the armpit of the world economy in terms of massive unemployment and depressions. Worse their inexcusible and insane proclivity to Ponzi debt pyramids is creating a financial time bomb of nuclear proportions. Unfortunately EU policy makers are too stupid and ignorant of basic economics and risk management to understand this! Their ideology trumps reason. What sane person wants to be part of this club of losers and mental retards, but then why do so many have to suffer for the decisions of a few in Brussels?

wyattJune 14th, 2012 at 3:20 am

As an American living in Italy during the change over from the lira to the euro, it was quite something to experience. I think in the main, most people aren't aware of how radical a currency change can be. The ratio of exchange was something like 1900 lira to one euro. I remember that overnight prices on some things practically doubled, and there wasn't much comment about it. The 1000 lira note seemed to have had much more value than the 50 centesimi piece that replaced it. People's sense of values were upended and they were taken advantage of because of it, so things that previously had cost 1000 lira, now were coming in at one euro, which was almost 2X the former price. My feeling at the time was that the continent wasn't really ready for a common currency, that the pace of change was being forced by idealistic rather than practical and/or timely considerations.

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