Why a Break-Up of the Euro May Be a Good Thing

Jonathan Tepper|Partner and Chief Editor, Variant Perception
Wednesday, 4 Apr 2012 | 10:47 AM ET

Most economists expect catastrophic consequences if any country exits the euro. Like most conventional wisdom, such a view will be contradicted not by opposing ideas but by the march of events.

European Bank Note
Sabine Scheckel | Image Bank | Getty Images
European Bank Note

If the euro broke up, it would not be the first currency union ever to come apart. Within the past 100 years, there have been sixty-nine currency breakups. Astonishingly, almost all of the exits from a currency union have been associated with low macroeconomic volatility. In almost all cases, the transition was smooth and relatively straightforward. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan in 1947, Pakistan and Bangladesh in 1971, Czechoslovakia in 1992-93, and the USSR in 1992.

Why would the breakup of the euro be a crisis, then? Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripherallevels of net external debt exceed almost all cases of emerging market debt crises that led to default and devaluation. Any exit from the euro would inevitably re-introduce devalued drachmas, pesetas, escudos, punts or lire, because of extremely overvalued real effective exchange rates and very high net external debt levels.

The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit. The real problem in Europe is that EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and very high external debt levels. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable.

European politicians do not want to contemplate the end to an ambitious economic project like the euro. However, Greece and Portugal, and perhaps Spain, Ireland and Italy will ultimately conclude that it is in their best interest to exit the euro. When they do so, they will be able to draw on historical examples to guide them.

While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers.

The move from an old currency to a new one can be accomplished quickly and efficiently. All local money and debt would be redenominated into a new currency. Typically, before old notes and coins can be withdrawn, they are stamped in ink or a physical stamp is placed on them, and old unstamped notes are no longer legal tender. In the meantime, new notes are quickly printed. Capital controls are imposed at borders in order to prevent unstamped notes from leaving the country. This entire process is not easy but it can be accomplished in relatively simple and transparent steps.

Defaults and debt restructuring should be achieved by exiting the euro, re-denominating sovereign debt in local currencies and forcing a haircut on bondholders. Almost all sovereign borrowing in Europe is done under local law. This would allow for a re-denomination of debt into local currency. Devaluing and paying debt back in drachmas, liras or pesetas would reduce the real debt burden.

Critics of exiting the euro point out that financial panic would destroy capital and harm European banks . It is worth bearing in mind the words of John Stuart Mill, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” Withdrawing from the euro would merely unwind existing imbalances and crystallize losses that are already present.

The ugly truth that European politicians do not want to admit to is that the euro is like a modern day gold standard where the burden of adjustment falls on the weaker countries. Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionarybias, where the burden of adjustment is always placed on the weak-currency country, making the euro a modern day debtors’ prison.

Any exit from the euro would undoubtedly be painful. There is a silver lining, however, to exiting and devaluing. Countries that have defaulted and devalued have experienced short, sharp contractions followed by very steep, protracted periods of growth. The eurozone periphery is likely to be different though. Rapidly ageing populations and a structural propensity to overspend in by the government mean that root and branch reforms are needed. However, such reforms are impossible in the current regime.

Exiting, devaluing and defaulting would allow periphery countries to emerge from the crisis with delevered balance sheets and more competitive exchange rates. The European periphery would then stand a more realistic chance of restructuring their economies. In most cases of external debt crises, real GDPdeclined for only two to four quarters (for example, Asia 1997, Russia 1998, Argentina 2002). Furthermore, real GDP levels rebounded to pre-crisis levels within two to three years and most countries were able to access international debt markets quickly. If history is any guide, exiting may be the only chance the European periphery has to heal itself, and any exit will likely be one of the greatest investments of recent years.

Jonathan Tepper is the co-author of the NY Times bestseller "Endgame: The End of the Debt Supercycle," a book on the sovereign debt crisis. Jonathan is the Chief Editor of Variant Perception, a macroeconomic research group that caters to asset managers. He is also the portfolio manager of an equity long/short hedge fund at Hinde Capital.

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