Easy Street

Europe: Nooobody Expects the Spanish Inquisition. Yet.

Heidi Moore Sep 7, 2011

If you thought America’s problems – four years into the financial crisis aftermath – were bad, it’s particularly sobering to realize that Europe, also four years into the same crisis, has problems that are just beginning.

Including, potentially, authoritarian regimes and endless civil wars reminiscent of the Soviet Union, according to UBS economist Stephanie Deo, who discussed the economic cost of a potential breakup of the Eurozone in a research note yesterday.

But….the economic cost? Pffft. That’s kid stuff compared to the really big issues.

Deo – who believes the Eurozone should never have existed and that it has hurt its member countries – is more concerned with the political cost and the dark civil disorder that could descend on Europe if the eurozone breaks up. (Which is, by the way, a very good answer to the question that Dorothy Parker often raised: What fresh hell is this?) Deo’s message is that a eurozone collapse would not be just an economic collapse – it would be a political, social and financial breakdown of entire countries as we know them:


The economic costs is, in many ways, the least of the concerns investors should have about a breakup. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease….It is also worth observing that no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.


The Easy Street glossary entry here is for “fiat currency system:” that just means paper currency, as opposed to gold or silver.

As for “monetary union,” it can mean anything from the former Soviet Union to the United States itself (different states united by the same currency).

For instance, another UBS economist, Paul Donovan, reminded his clients back in February 2010 that the United States really only became unified under a single monetary system in 1933. Here’s his history lesson:

Although the US dollar was mandated as the single currency of the continental
United States, the existence of the US monetary union in economic terms was
limited in the early years of the Republic. Indeed, during the US Civil War a
total of three currencies circulated – the Confederate dollar, the Union’s
“greenback” and a gold backed dollar (which was called, with some originality,
the “goldback”).

With the operation of the Federal Reserve System in 19141 the United States
began to approach a “genuine” monetary union. However, the different Federal
Reserve banks did not share an entirely common interest rate policy. Instead, the
discount rates of each bank could (and did) differ from district to district. There
was also a persistent tension between the Board in Washington (now known as
the Board of Governors) and the heads of the regional Reserve banks (then
known as Governors, confusingly, and now known as Presidents).

But back to the main event: the breakdown of civilization. Deo reasons that any collapse of a “monetary union” has never happened in modern times without violence. Even in 1933, at the height of the crisis portion of the Great Depression and one day after Franklin D. Roosevelt’s swearing-in, three states – New York, Illinois and Pennsylvania – shut down their banks after nearly a year of bank runs that threatened to destabilize the entire country. The New York Stock Exchange and the Chicago Board of Trade both shut down. State militias were sent out to impose order.

The journalist Earle Looker wrote later that year about Roosevelt’s “beleaguered capital in wartime,” and asked,, “Capitalism itself was at the point of dissolution. Would men continue to work for profit as our forefathers understood it and as our people now understand it? This was important, for money was now useless.”

As it was in 1933 – and ever since – the problem with political meltdowns is how they affect the banks.

So, that kind of thing – militias, authoritarianism- could happen in Europe if the Euro breaks up. Deo notes that the breakup of Czechoslovakia in 1993 led the countries to seal their borders and limit bank withdrawals. When the Soviet Union broke up, one big authoritarian regime was replaced by civil wars leading to smaller authoritarian regimes.

Deo notes, “the political costs of breaking up the Euro, even in part, are too great to quantify in bold cash terms.”

She explains, “Past instances of monetary union breakups have tended to produce one of two results. Either there was a more authoritarian government response to contain or repress the social disorder (a scenario that tended to require a change from democratic to authoritarian or military government), or alternatively, the social disorder worked with existing fault lines in society to divide the country, spilling over into civil war.”

She adds, for those politicians who may scoff, perhaps, “These are not inevitable conclusions, but indicate that monetary union break-up is not something that can be treated as a casual issue of exchange rate policy.”

Sing it, sister. A breakdown of civilization usually reliably follows financial troubles – in Europe or anywhere else.

Even though the political costs of a breakup – and the ensuing disorder – are not quantifiable, the financial costs may be, and luckily for those of a more mathematical turn of mind, Deo takes a stab at them. First, it’s important to establish that she dislikes the Eurozone:

“The Euro should not exist (like this)…Under the current structure and with current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change….Member states would be economically better off if they had not joined.”

The Eurozone is an unsustainable fair-weather friendship, you say? Well, that idea is an old one.

But Deo takes that old chestnut and actually adds something to the sum of human knowledge by predicting, in very stark terms, what would happen if the Eurozone collapsed. And collapse, in this instance, could well mean even one country leaving. It would hurt the Eurozone, yes – but, Deo predicts, it would hurt the country that leaves even more. That’s true whether the country is a strong one, like Germany, or a weak one, like Greece.

For instance, if a weak country left the Eurozone, that country would have to build up its financial system on its own, including banks and companies, as well as establish an international-trade policy from scratch. That would cost as much as 11,500 euros to each person in that country for the first year, and then 4,000 euros every year after that. Deo estimates the hit would amount to 40% to 50% of GDP in the first year.

Even if a strong country, like Germany, were to leave the Euro, would be as much as 8,500 per person in the first year and 4,500 per person in every year after that, Deo predicts.

But Deo leaves her coldest, darkest advice for last. When advising clients on how to invest to prepare for a Euro breakup, this is her conclusion:

“The only way to hedge against a Euro break-up scenario is to own no Euro assets at all.”


Bonus Viewing

This is all pretty heavy material to absorb, so if you need something lighter to cleanse your palate, check out a Monty Python skit on the Spanish Inquisition that inspired this headline. If you’re not a Monty Python fan, this is an excellent time to start. You’ll need a sense of humor for the next 15 years of the Eurozone crisis.

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