Costs of a collapse of the Euro

A collapse of the European Monetary Union (EMU) and a return to their previous currency for each member country would have severe economic impacts. With focus on monetary effects, I will discuss the pros and cons of a collapse of the EMU. Based on these effects, costs can be estimated and put into perspective to a bailout. Costs of a collapse of the EMU significantly outweighs costs of a bailout.

Starting with the pros for a collapse, each countries will regain control over monetary policy. With the ability to set interest rates, the domestic central banks can control the demand of money. Second, monetization gets under direct control of the country. Debt monetization allows governments to issue debt for financing its spendings. The debt is purchased by the central bank resulting in an increased supply of base money. Third, the currency can be allowed to depreciate to increase exports. Consequentially, imports become more expensive, which can boost a domestic import substitution industry but impede industries relying on imports.

These effects are countered by three main costs. The market assesses investment options based on returns and risk. An investment in a foreign currency becomes less profitable if the foreign currency is subject to high inflation. Therefore, investment or the borrowing of money for a country becomes more expensive if risk of inflation is high. The Euro has a reputation of very low inflation making money comparably inexpensive. A return to domestic currencies can deter investors especially if the currency is likely to depreciate because of inflation. With higher yields for higher risks of inflation, money becomes more expensive. In turn, this can bring a solvent country into liquidity problems and lead over a circle of higher yields to insolvency. This can lead to a capital flight tightly connected to the next point: The banking system is likely to collapse because depositors move money out of the country to prevent being subject to depreciation or default. Third, national savings will be denominated into the domestic currency. For countries with an expected depreciation, the process of redenomination will in fact eliminate national savings. No savings and a staggering inflation can quickly raise civil unrest.

Core and peripheral countries mainly differ in the expected depreciation or appreciation of their currencies. The Euro is a weighted average of all economies. Consequentially, core countries like Germany would see their currencies appreciating while peripheral countries like Greece would be subject to a strong depreciation. Appreciation of a currency attracts investments although the foreign exchange market usually quickly adapts to a new economic situation. However, an appreciated currency makes exports less competitive in the world market. Core exporting countries would suffer substantial losses from decreased exports. In addition, core countries, which are net creditors like Germany, would also suffer with their credits denominated in a weaker currency than the new ‘domestic’ currency. Along the same line, peripheral countries would gain from more competitive exports but might suffer from expensive imports. Peripheral net debtors would see their debt denominated in a foreign currency, which appreciates relative to the ‘domestic’ currency. Therefore, debt repayment would become more difficult to impossible. Investors fearing a default will increase yields, make money more expensive and, thus, increase the likelihood of a default by increasing the interest burden on the countries severely limiting any investment.

A study conducted by UBS estimated costs per capita for core and peripheral countries based on the described effects. A peripheral country like Greece would suffer from estimated costs of around 10,000 Euros per person in the first year with annual follow-up costs of about 3,500 Euros per person for the next five years. This translates into 40 to 50% of GDP in the first year and subsequently annual costs of about 15% of GDP. Thus, a peripheral country would see no GDP growth relative to the current GDP for several years if not decades.

The same study also estimates costs for core countries like Germany. Cost estimations yield about 7,000 Euro per person in the first year and 4,000 Euro per person in each subsequent year. This equates to around 20 to 25% of GDP in the first year and about 10 to 15% for each following year. Therefore, also core countries would suffer for years from the collapse with a huge GDP contraction and years or decades before the current level of GDP could be achieved again.

Putting these numbers into a perspective, costs of a complete bailout of Greece, Ireland and Portugal are rather moderate with about 1,000 Euro per person.

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