After the fall: The costs of break-up:

Economist
September 17, 2011

The costs of efforts to save the euro are justified by the claim that the alternative would be too dreadful to contemplate. But economic history is littered with examples of fixed exchange rates that came unfixed; the disuniting of currency unions, though rarer, happens from time to time. So how do the costs of sustaining the euro compare with the costs of its falling apart?

The question does not have a simple answer. For a start, there are lots of different ways to fall apart: a wholesale dissolution into the original currencies; a fissioning into northern hard-currency and southern soft-currency blocks; or the exit of a trickle of countries, or just one. Further complexities come from the panoply of choices the departing and remaining states would make after the fall. And all this turns as much or more on law and politics as on economics.

Take two specific scenarios. Germany could leave, either on its own or with a select group of small economies—Austria, Finland and the Netherlands—as recently suggested by Hans-Olaf Henkel, a former head of the Federation of German Industries. Second, and more likely, Greece might secede or be forced out.

In each instance, the economic consequences could be devastating, argue many analysts. If Germany were to leave, its Neue Deutschmark would soar as international funk money piled into a bigger, better Switzerland, and German manufacturing firms would suffer. German banks could cope with the switch of domestic deposits and loans into the new currency, but they would have to be recapitalised because their foreign assets in euros would now be worth less in domestic terms.

If Greece were to leave, its reborn drachma would plummet—which might be good for its exporters but which would trigger what Barry Eichengreen, a monetary historian at the University of California, Berkeley, has called “the mother of all financial crises”. The devaluation of the drachma against the euro would turn any debts that remained in euros into a crippling burden. At the same time depositors, who are already edging towards the exit, would break into a headlong rush, bringing down Greece’s banking system.

A recent study by economists at UBS, a Swiss bank, suggested that the costs in each of these eventualities would be forbiddingly high. If Germany were to leave, it would incur costs worth 20-25% of GDP in the first year and then roughly half that amount in each subsequent year. If Greece were to quit, the first-year cost would be 40-50% of GDP, and subsequent annual costs would be around 15%.

Such costs dwarf the one-off expense to Germany of bailing out Greece, Ireland and Portugal were they to default. But the report is based on the extreme assumption that countries leaving the euro would have to leave the EU. There is a legal argument for this position, but politics would almost surely trump it. It would not be in the broader interest of Europe to have an embittered neighbour in the eastern Mediterranean, or to cut Germany adrift. European policymakers would be hellbent to conserve the single market rather than immolate it in the bonfire of the euros. This suggests that the economic impact of a break-up would be less catastrophic than envisaged by the UBS economists.

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