Disbanding The Euro - A Worst-Case Scenario

Disbanding The Euro - A Worst-Case Scenario

Released on - Wednesday,23 June , 2010 -11:56 00

Only time will tell if we are past the worst of the debt crisis in Europe, or simply enjoying a calm amidst the storm. In either case, the crisis in Greece and the fears of its spread into Spain, Italy and Portugal have led many financial analysts and commentators to seriously consider what had once been mostly the domain of crackpots - the notion that the euro could collapse and vanish altogether.

This is no small matter. Of the 10 largest economies in the world, four use the euro as their currency. Roughly 330 million Europeans use the euro every day, while nearly 200 million people use currencies that are pegged to the euro (many of them in Africa). It is also the second most-used currency as a reserve currency, with roughly one-quarter of the world's reserves held in euros.

Step 1 - Panic

The immediate consequence of the collapse of the euro would most likely be a great deal of volatility and chaos. Given that market participants generally loath chaos, it would probably mean some ugly days for global stock markets and lower interest rates in the U.S. as investors flea into U.S. government bonds. In a perhaps ironic twist, though, it would not be entirely shocking if some markets rose on the news - investors in Britain, Germany and countries like Denmark and Sweden may see the fall of the euro as beneficial to their countries.

Step 2 - Pay More, Get the Same

With the euro disappearing, there would be an increase in the costs of doing business with and within Europe. Banks do not exchange money for free, and so companies would face higher transaction costs as the number of their operating currencies would increase. In other words, companies would not necessarily have any expectation of selling more product to the current eurozone (in fact, there could be lower demand), and those sales would now be more expensive.

In addition, risk has a price and the risk of multiple volatile exchange rates would impose an economic cost as well. It is difficult to price the cost of exchange rate volatility, but economists have theorized over the years that it could be a figure in the range of 1-5%, expressed both as a percentage of assets or revenue involved and national growth rates.