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How Painful Would an Euro Zone Exit Be? Very.

Moorad Choudhry, Head of Business Treasury, Global Banking HKSCKPVIamp; Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University
Wednesday, 16 Nov 2011 | 4:44 AM ET

The euro crisis rumbles on. Prime ministers are changing as a direct result of the currency’s troubles, although really what this illustrates is that the countries affected were already in a lot of economic trouble anyway; it’s just that their membership of the euro currency union speeded up the change in government.

European Central Bank
European Central Bank

One cannot build a monetary union project over a number of years and then expect to overhaul its operation in a matter of months.

That is one reason for the slow progress in dealing with the crisis; the other of course is that there isn’t an agreed approach in place in the European Union.

And as The Smiths so rightly pointed out, These Things Take Time … but at the heart of the euro’s troubles is the philosophical debate about what the EU really wants itself to be: free trade area or political union?

In an effort to help speed up the decision making, this week’s column addresses the following debating point:

It is possible for a country to undertake an orderly withdrawal from the euro zone. Discuss.

There are plenty of people who agree with this statement.

Some high-profile people in both business and academia have suggested that Greece, for example, should withdraw from the euro, thereby freeing itself from its current monetary straitjacket, benefitting from a currency devaluation and more appropriate base interest rate.

It is possible to withdraw from the euro, certainly, but it is difficult to see how the process would be orderly.

Here is why: the instant that an announcement is made that a country will be reverting to its national currency, there will be a run on that country’s banks, as every depositor seeks to take his/her euros out.

Instant Bank Crisis

This will cause an instant bank crisis. No ifs, no buts, this is a certainty. Unless the government introduces the change by stealth of course (one wakes up one morning to find that one’s euro deposit is now in a different currency), in which case we would observe some serious civil unrest.

The bank crisis would not be limited to the country in question, which is why it is such a scary prospect.

The knock-on effect would be felt throughout the EU and would result in an instant freezing of the inter bank market, with disastrous results as one can imagine. Central banks would come under renewed pressure to extend even more market liquidity, and a number of banks would go under.

The euro zone leadership can allow for this in advance by announcing a state-funded backstop for failing banks, to help to maintain confidence, but no-one should think that market conditions would be anything other than very difficult for some time. And sovereign authorities are struggling with their existing borrowing requirements, without having the expense of recapitalising banks – just look at the latest southern euro zone funding spreads relative to Germany.

This is why no matter how painful a default and restructuring of individual euro members would be, it will still be less painful than trying to restore a national currency.

Given this reality, it is understandable if one were to conclude that trying to arrange an orderly withdrawal from the euro is akin to trying to arrange a non-violent cage fighting tournament.

It is certainly a policy option for the EU, but we should be under no illusions as to how painful the outcome would be for the global economy.

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Prof Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.

The views in this article represent those of Moorad Choudhry as a private individual, and do not represent the views of Royal Bank of Scotland or London Metropolitan University.

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