The European Union (EU) had a rough first six months of 2016. The United Kingdom voted to leave, though the Brexit process will not be complete until 2018 at the earliest. There are major banking troubles at Deutsche Bank AG (NYSE: DB), Credit Suisse Group AG (NYSE: CS) and virtually every Italian financial institution. Greece remains in terrible shape economically, and several other countries are at least heading in that direction. The final nail in the coffin might be the ineffective policies of the EU's overly bureaucratic government in Brussels, and the European Central Bank (ECB), which threw in negative interest rates as a Hail Mary to spur growth. A distressed euro may be looking at the brink, and the entire eurozone may not be far behind.
Current Pressures
The clearest danger to the eurozone is further defection from prominent governments. There are popular movements in France, Spain, Italy, Sweden, Belgium, Germany, Hungary and Poland for a U.K.-style referendum. Greece is consistently flirting with economic collapse and may be the first to leave the euro, though its foreign creditors might also suffer if repaid with devalued Greek drachmas.
End of the Schengen Area
A collapsed euro would likely compromise the so-called “Schengen Area,” named after the 1995 Schengen Agreement. Under this agreement, 26 separate European countries agreed to allow free movement of people, goods, services and capital within the borders of the eurozone. Not every member of the EU is also a member of Schengen, and not every participant in Schengen is part of the EU, but a collapse of the euro would nonetheless affect countries inside and outside of the region.
Economically, it is certainly possible to have competing currencies in the same economic zone. There is nothing preventing Germans or Italians from trading in both German deutsche marks and Italian lira, for example. That scenario only seems unlikely because an end to the euro would increase pressure to dissolve the entire EU experiment.
If Schengen falls, there are immediate practical costs to consider. Countries inside the eurozone would need to implement border controls, checkpoints and other internal regulations previously eliminated in the Schengen Agreement. These costs would spill over into private businesses, especially those relying on continental transportation or tourism.
To the extent that import quotas or tariffs are implemented by various member nations, and to the extent that those measures are reciprocated elsewhere, it would be a corresponding decline in international trade and economic growth. It is clear that the collapse of the euro would affect more countries than just European ones, though in uncertain ways. Other regions, especially major trading partners in North America and Asia, would face financial and possibly political consequences.
Impact Outside the EU
Many of the supposed economic benefits inside the EU did not transfer to external trading partners. The freedom of labor and capital did not extend to the United States or China, for example, unless foreign consumers and producers gained access to a member country. This makes it difficult to predict potential fallout, since it is possible that even stronger pro-growth policies could replace the bureaucratic super-state seated in Brussels. On the other hand, increased economic isolationism from nationalist movements threatens international businesses and financial markets.
In the very short term, markets would likely react negatively to added uncertainty. The EU is a known commodity, even if imperfect, and markets like predictability. In the longer term, however, the markets could certainly benefit from a once-again growing Europe. Between 2010 and 2015, Europe lagged significantly behind the Americas, Africa, Asia and the Pacific regions in real gross domestic product (GDP) growth. If a post-euro world returns continental Europe to competitive economic growth, it is very likely that the global economy will benefit.
Switching Back to National Currencies
The official term for leaving the euro and installing an old currency is called “redenomination.” Such a conversion would almost certainly be less complicated than coordinating the adoption of the euro in 2002, but investors should still be wary of uncertainty.
Essentially, the redenomination boils down to two broad changes. The first is the official adoption of a new currency within one nation’s boundaries. This means adjusting present wages, prices and other values to the new money in an approximately proportionate basis. Second, the international value of the currency needs to be priced into foreign exchange (forex) markets. This is based on many factors, including the productive capacity of each national government and the relative risk of devaluation for its currency.
It is likely that many indebted countries with lots of foreign creditors, such as Greece, would try to redenominate in such a way as to reduce their real repayment burden. One way to accomplish this is to redenominate and immediately begin a strong inflation, thus reducing the purchasing power of the repaid debt. Economists sometimes refer to this as “instant internal devaluation.” The downside to such a policy is that it creates havoc in the devalued country’s economy, since bank accounts, pensions, wages and asset values all suffer.
Close historical parallels can be found after the collapse of the Austro-Hungarian Empire, which stood between 1867 and 1918. After the empire fell apart, many member countries hoped to retain the Austro-Hungarian krone as currency. Unfortunately, several irresponsible governments used highly expansionary monetary policy to pay off the high debts from WWI, triggering hyperinflation in Austria by the early 1920s. Slovenia, Hungary and others experienced much of the same. By 1930, each former member nation had to use a new currency, often backed by gold or silver.
Impact on Banking, Forex and International Trade
If all that changed were the euro being replaced by competing national currencies, then the abolition of the euro would only create real long-term changes in monetary policy. The eurozone was originally sold, in part, by the concept of creating a European counterpart to the U.S. Federal Reserve. Getting rid of the euro would decentralize monetary authority back to the member nations; for example, a German central bank would control interest rates and the money supply in Germany, while a Portuguese central bank would control them in Portugal.
Banks could otherwise recapitalize in their national currencies, although they would likely have to keep more active foreign exchange balances for regional trade and reconciliation. The various exchange rates would change the relative values of some assets held internationally, and the workers in less-inflationary European job markets would see a relative income boost compared to European governments with loose monetary policy. For example, it is likely that workers in highly productive Germany would have an easier time affording goods and services produced in less-productive Slovenia.
However, it is very unlikely that other economic policies would remain unchanged if the euro failed. Even if the EU technically survived, other restrictions could be implemented on immigration or trade. Pro-euro parties would likely suffer political consequences, allowing for nationalistic parties to gain influence and maybe implement new fiscal policies. If Schengen also failed, the economic consequences could be extremely disruptive, even if only for the short term.
