How to Break Up the Euro

A prize-winning analysis shows how one or more countries might go about exiting the euro zone and what the fallout could be.
Andrew SawersJuly 11, 2012

A 150-page report detailing how a breakup of the euro could happen has won a six-digit prize — payable in British pounds. Consultancy Capital Economics and lead author Roger Bootle won the £250,000 Wolfson Economics Prize for setting out “how best to manage the orderly exit of one or more member states from the European Monetary Union.”

The bulk of the paper is written as though Greece were the first to leave the euro and that it relaunches the drachma, but the authors say the issues would be the same whichever vulnerable, peripheral country were to leave first.

Here’s what the authors say could happen:

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Core north: The economists reckon it’s possible just one country will leave the euro. At the other extreme would be a complete breakup with all countries reverting to national currencies. A third scenario would be an optimal reconfiguration of the euro centered around a northern core, comprising Germany, Austria, the Netherlands, Finland, and Belgium. France, they say, isn’t an obvious candidate for membership of this core on economics grounds, but political considerations would be likely to dictate that it does indeed join.

Separate south: However, southern currencies that exit the euro would each go their own way rather than form a soft, “southern euro” bloc. That’s because of their economic diversity and their relatively low level of trade with one another.

One-to-one: For any currency that leaves the euro, a currency conversion and redenomination of domestic wages, prices, and other domestic monetary values into a new currency would be swiftly followed by a devaluation of that currency against the euro. The ideal exchange rate for such a conversion would be 1:1, or parity with the euro.

Secret sauce: Would this all be kept secret until the last possible minute, or done in the open? Secrecy would help minimize — or at least delay — such disruptive effects as capital outflows, falling asset prices, rising bond yields, and depressed consumer and business confidence. The report’s authors note that South Sudan managed to secretly print a complete supply of bank notes in the six months before it declared independence last year. Still, in Europe they don’t think that anything other than the early stages of planning for an exit could be done in secrecy.

Contracts: A real problem is what the impact would be on commercial contracts drawn up in euros. Relevant questions would include whether a contract is governed by the law of the exiting country, and whether references to the euro would be taken to mean the “international currency of the European Union” or “the national currency of the country at the time.” In Greece, for example, a domestic contract would probably be repriced in “new drachmas.” That’s less likely to be the case for a contract governed by some other country’s law, even if it means severe financial pain for one party to the contract or another. Moreover, it’s clear from International Swaps and Derivative Association Master Agreements that contracts in euros would continue to be in euros.

Cash: Hard cash is a big imponderable because, despite South Sudan’s experience, it’s pretty difficult to print and distribute vast amounts of cash. The lead time is about six months to create enough new drachma notes and coins. Overstamping euro bank notes with “new drachma” is mentioned but quickly discarded as a possible way of creating enough cash in the short term, the problem being that no one will voluntarily surrender cash to be overstamped. The authors put forward a novel, if brave, solution: do without cash for the time being. They say that would be “a difficulty [but] it is not as serious as it might seem at first.” Credit or debit cards, checks, and even IOUs could take the place of cash. Indeed, they say, cash has been for decades “the small change of the economic system.”

Capital controls: To prevent a collapse resulting from a run on the banking system, capital controls will have to be in place. Although the European Central Bank currently stands ready to provide a blank check that would prevent such a flight of money, it’s risky to rely on that support always being there. In particular, when the redenomination is announced but before the new drachma cash is ready, cash machines (ATMs) would have to be shut down.

Devaluation: New currencies could be devalued 40% against the euro in Greece or Portugal, 30% in Spain and Italy, and perhaps just 15% in Ireland. In all cases, though, markets may overshoot those levels before bouncing and recovering a little.

Timetable: No more than a month ahead of an exit, secret planning would likely take place, with capital controls prepared in case secrecy is breached. On a Friday, euro-zone partners would be told of the exit. Over the weekend, announcements would be made and new cash ordered. On Monday the new currency would be introduced at 1:1 to the euro. Within three to six months, notes and coins would be available, and the conversion would be complete.

The full report covers these issues in much more detail as well as the impact on prices, household finances, renegotiating debt, and more.

Lord Wolfson, chief executive of U.K. fashion retail group Next plc, funded and launched the prize last October “in the unshakable belief that the more thought and preparation that goes into a breakup, the less damaging a collapse would be,” he said.

Andrew Sawers is editor of CFO European Briefing, a CFO online publication.