Citi GPS: Global Perspectives & Solutions
What Happens if the Euro Collapses?
By Willem Buiter
8 December 2011 – A break-up of the Euro Area would be rather like the movie ‘War of the
Roses’ version of a divorce: disruptive, destructive and without any winners. A break-up of
the 17-member state Euro Area, even a partial one involving the exit of one or more fiscally
and competitively weak countries, would be chaotic. A full or comprehensive break-up, with
the Euro Area splintering into a Greater DM zone and around 10 national currencies would
create financial and economic pandemonium. It would not be a planned, orderly, gradual
unwinding of existing political, economic and legal commitments and obligations.
It took seven years of careful preparation and planning to launch the then 11-nation Euro
Area in 1999. Exchange rates of the 11 candidate national currencies converged smoothly
to the irrevocable euro conversion rates agreed among the member states well in advance.
Even the fiscally weak and uncompetitive Euro Area candidates had, under pressure to
meet the Maastricht criteria for euro area membership, engaged in years of fiscal austerity,
inflation convergence and domestic cost control prior to entry. Although we now know that
there was extensive fiddling of the national data used to verify fiscal compliance with the
Euro Area membership criteria, even the most egregious corner-cutters made serious efforts
to comply. The creation of the euro was not accompanied by sharp and unexpected last-
minute currency revaluations.
In contrast, exit, partial or full, would likely be precipitated by disorderly sovereign defaults
in the fiscally weak and uncompetitive member states, whose currencies would weaken
dramatically and whose banks would fail. If Spain and Italy were to exit, there would be a
collapse of systemically important financial institutions throughout the European Union and
North America and years of global depression. Even if the likelihood of an eventual exit or
break-up were to be assessed accurately by the markets – something for which there is
preciously little evidence – the timing of any exit or break-up is bound to come as an
unexpected and deeply disruptive event.
Consequences of Exit or Break-up
Three kinds of consequences of exit or break-up can be distinguished: First, balance sheet
or portfolio revaluation effects; second, international competitiveness effects, and third,
procedural, redenomination or legal effects.
Consider the exit of a fiscally and competitively weak country, say Greece - an event to
which I assign a probability of around 20 or 25 percent. Following exit, most contracts,
including bank deposits, sovereign debt, pensions and wages would be redenominated in
New Drachma and a sharp devaluation, say 65 percent if we take the collapse of Argentina’s
currency board in 2001 as a guide, of the new currency would follow. Consequently, as
soon as an exit is anticipated, depositors will flee Greek banks and all new lending and
funding governed by Greek law will cease. Even before the exit occurs, the sovereign, the
banking system and indeed any enterprise in the real or financial sectors dependent on
external finance will be at high risk of failure because of a lack of funding. Following the
exit, contracts and financial instruments written under foreign law will likely remain euro-
denominated. Balance sheets that were thought to be balanced in the absence of
redenomination risk will become severely unbalanced and widespread default, insolvency
and bankruptcy will result. Greek domestic demand and output will collapse.
Without continued support from the troika facilities and even from the ECB for the exiting
member state(s), there could be cash points running out, depositors and savers besieging
banks, riots and shortages of food and other essentials.
An exiting country, facing massive disruptions in its international capital account transactions
would need to impose strict capital and foreign exchange controls following exit if some
semblance of financial order is to be maintained. However, Article 63 of the Consolidated
Version of the Treaty on the Functioning of the European Union does seem to rule out the
imposition of capital controls and payments controls not only between 27 members of the
EU (regardless of whether they are members of the Euro Area or not), but also between
members of the EU and countries outside the EU, so-called third parties. Article 63 states:
“1. Within the framework of the provisions set out in this Chapter, all restrictions on the
movement of capital between Member States and between Member States and third
countries shall be prohibited.
2. Within the framework of the provisions set out in this Chapter, all restrictions on payments
between Member States and between Member States and third countries shall be
Fortunately, for every Article in the TEU and the TFEU asserting that something is either
required or not allowed, there is another Article or Protocol asserting the opposite or
creating a loophole. TFEU Articles 346, 347, 348 and 352 invoke the threat of war, serious
internal disturbances and other unforeseen contingencies as grounds for overriding Treaty
clauses and other legislation, and provide mechanisms for implementing such overrides.
Articles 258-260 provide a blueprint for how the European Commission, other member
states and the European Court of Justice should handle a member state whose actions are
not in compliance with the Treaty. This seems tailor made for countries introducing capital
controls following an exit from the EMU.
Good Will is Essential
In the EU, as in life, love normally finds a way around mere Treaty-based and legal
obstacles to common sense. But good will is essential. If a country were to exit in a haze of
confrontation and hostility, it is unlikely it would be shown the kind of forbearance that is in
principle possible in a consensual exit. In the worst-case scenario, exit from the Euro Area
would precipitate exit from the EU.
The sharp decline in the New Drachma's external value following exit would temporarily give
Greece a competitive advantage. But Greece (like Portugal, Spain and Italy) does not have
the persistent nominal rigidities found in more Keynesian economies like the US, the UK
and perhaps even Ireland that would turn a depreciation of the nominal exchange rate into a
lasting competitive advantage. Soaring wage and price inflation, driven by the collapse of
the currency itself and by the monetisation of the likely remaining government budget deficit,
would quickly restore the uncompetitive status quo. The official forecast that the Greek
general government sector will run a primary (non-interest) surplus in 2012 looks optimistic.
In addition, the Greek sovereign’s debt under English and New York Law, including its
borrowing from the IMF (with its preferred creditor status) and from other official creditors
(including the Greek Loan Facility and any borrowing from the EFSF or the ESM that
Greece may yet engage in) are unlikely to be repudiated or written down following a Greek
exit. A sizeable government deficit would remain to be funded. Monetisation of the
remaining deficit through the issuance of a New Drachma, for which there would be very
little demand as the Greek economy would remain informally eurosised to a significant
degree, may well be the only funding option.
Greece’s continuing current account and trade deficit, reflecting its private sector financial
deficit as well as its government deficit, would be impossible to fund in the short term.
Without external funding, imports would collapse, further disrupting domestic production
already weakened by collapsing domestic demand. Aggregate demand and aggregate
supply would chase each other downwards.
If Greece storms out of the EA, something that has become more likely following the
growing political unrest and economic uncertainty and distress in the country, there might be
little fear other countries would follow suit. However, if Greece is de facto pushed out of the
EA, say because, following another attempt by Greece to renegotiate the terms of its
financial support package and/or wilful non-compliance with the terms of the troika
programme, other member states refuse to fund the Greek sovereign and the ECB refuses
to fund Greek banks, the markets could beam in on the next most likely country to go. This
would prompt a run on that country's banks and a sudden funding stop for its sovereign, its
financial institutions and its corporations. This self-fulfilling fear might force the actual
departure of the afflicted country. This exit contagion might sweep right through the rest of
the EA periphery - Portugal, Ireland, Spain and Italy - and then begin to infect the EA 'soft
core': Belgium, Austria and France.
A disorderly sovereign default and EA exit by Greece alone is manageable. Greece
accounts for only 2.2 percent of EA GDP and 4 percent of EA public debt. However, a
disorderly sovereign default and EA exit by Italy would bring down much of the European
banking sector. Disorderly sovereign defaults and EA exits by all five periphery states - an
event to which I attach a probability of no more than 5 percent, would drag down not just the
European banking system, but the north Atlantic financial system and the internationally
exposed parts of the rest of the global banking system as well. The resulting global financial
crisis would trigger a global depression that would last for years, with GDP falling by more
than 10 percent and unemployment in the West reaching 20 percent or more. Emerging
markets would be dragged down too. Even the limited financial turmoil emanating from the
Euro Area thus far has contributed to the marked slowdown of growth in the world’s three
most important emerging markets – China, Brazil and India.
Exit by Germany and the other fiscally and competitively strong countries would be possibly
even more disruptive. This might occur if there were attempts to introduce a one-sided
fiscal union with open-ended and uncapped euro-bonds or other transfers from the strong to
the weak without a corresponding surrender of fiscal sovereignty to prevent future crises or
if the ECB were to 'go Weimar'. I consider this highly unlikely, with a probability of less than
3 percent. Following the exit, Germany and the other core EA member states (perhaps
excluding France) would introduce the new DM. The sovereigns in the periphery would
default. The new DM would appreciate sharply. Financial institutions in the new DM area
would have to be bailed out because of losses from exposure to the old periphery and the
soft core. As nothing holds the remaining EA countries together, the rump-EA splits into
perhaps 11 national currencies. The legal meaning and validity of all euro-denominated
contracts and instruments is up for grabs. Everyone, except lawyers specialising in the Lex
Monetae, becomes much poorer as business is put on hold while the mills of the courts
Even if the break-up of the EA does not destroy the EU completely and does not represent a
prelude to a return to the intra-European national and regional hostilities, including civil wars
and wars, that were the bread and butter of European history between the fall of the Roman
empire and the gradual emergence of the European Union from the ashes of two made-in-
Europe world wars, the case for keeping the Euro Area show on the road would seem to be
a strong one: financially, economically, and politically, including geopolitically.
Willem Buiter joined Citi in January 2010 as Chief Economist. One of the world’s most distinguished
macroeconomists, Willem previously was Professor of Political Economy at the London School of
Economics and is a widely published author on economic affairs in books, professional journals and
the press. Between 2005 and 2010 he was an advisor to Goldman Sachs advising clients on a global
basis. He has been a consultant to the IMF, the World Bank, the Inter-American Development Bank,
the Asian Development Bank, the European Commission and an advisor to many central banks and
finance ministries. Willem has also held a number of leading academic positions, including Cassel
Professor of Money & Banking at the LSE between 1982 and 1084, Professorships in Economics at
Yale University between 1985 and 1994 and Professor of International Macroeconomics at Cambridge
University between 1994 and 2000. Willem has a BA in Economics from Cambridge University and a
PhD in Economics from Yale University. He has been a member of the British Academy since 1998
and was awarded the CBE in 2000 for services to economics.
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