Outside the Box

A Primer on the Euro Breakup

February 28, 2012

It's one thing to say that peripheral eurozone countries are better off leaving the euro, but how, exactly? And how severe can we expect the consequences to be, not only for those nations but also for the entire eurozone – and for the rest of us, worldwide? To minimize fallout from the event(s), it would be helpful to have a solid foundation, based on an historical understanding of similar events, on which we could build a reasonable set of expectations.

In the following piece, Jonathan Tepper, my Endgame coauthor, gives us the cornerstone of just such a foundation. With his London firm, Variant Perception, he has prepared a 53-page report with the very confident title "A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution."

He reminds us that "during the past century sixty-nine countries have exited currency areas with little downward economic volatility." He makes the case that "The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit."

The real problem in Europe, he says, is that "EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and external debt levels that are higher than in most previous emerging market crises."

The way through? "Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. Exiting from the euro and devaluation would accelerate insolvencies, but would provide a powerful policy tool via flexible exchange rates. The European periphery could then grow again quickly with deleveraged balance sheets and more competitive exchange rates, much like many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, and Argentina 2002)."

We'll need this sort of robust thinking and a willingness to meet the challenge head-on if we're going to get through not just this eurozone crisis but the Endgame in which the whole world finds itself, in the final throes of the Debt Supercycle.

You can see the entire report on the Variant Perception blog – http://blog.variantperception.com/2012/02/16/a-primer-on-the-euro-breakup/ – or download it as a PDF.

Your confident that we will master the Endgame analyst,

John Mauldin, Editor
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A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution

This is an abbreviated version of a longer report which can be accessed at Variant Perception's blog at http://blog.variantperception.com, or as a PDF document. Contact us here to learn more about receiving Variant Perception research as a client.


Many economists expect catastrophic consequences if any country exits the euro. However, during the past century…

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igor cornelsen

March 7, 2012, 10:55 a.m.

In order to have a devaluation, a country needs to have a primary surplus. Greece doesn´t have one. They would have no means to continue to pay wages pensions and retirement checks. Greece would need to have food, medicine and oil. Argentina used to produce them domestically, Greece imports eveything.
Who will sell them for credit?
Ireland and Estonia used to have a current account deficit similar to Greece in 2007, or higher. The fiscal adjustment was made and the current account deficit vanished. They did not devalue and they turned around. Why Greece can´t do the same?
Finally the population of Greece does not want back the drachma, as it would mean their purchase power would shrink according to the devaluation, as everything is imported.
With or without a new currency, greeks have to start paying taxes, their public sector wages would have to be reduced to the same level of other countries, not higher. They would have to work harder and the reforms of the economy will have to happen.
Devaluation without reforms will just make them very poor again, as they were prior to the euro.
Devaluation is not panacea.

Ronald Nimmo

March 5, 2012, 9:58 p.m.

This is a very deep and comprehensive article full of information on a very timely subject, However, I would like to see a clear definition of the concepts in these lines:

In the case of Asian countries, most of the debt was denominated in another currency, ie dollars. This produced an “inverted balance sheet”. With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times and rise in bad times.

  I have read an article by Michael Pettis in which he discusses issues surrounding “inverted balance sheet”, but I didn’t see a real definition of what is meant by “positive correlation” between assets and liabilities”. It seems to me that Tepper may have learned the concept from Pettis’s writings. Can anyone give a precise definition?
  I want to understand this cause and effect relationship better, and it seems to me that a positive correlation between assets and liabilities would mean that as liabilities increase, assets would also increase. However, this meaning would not lead to the reinforcement of the vicious cycle described by Tepper and Pettis, but the opposite. So evidently the authors have a different idea of what “positive correlation” means from me.

bob erickson

March 3, 2012, 7:05 p.m.

It would appear that without a change in policy & attitude those countries will soon return to the same problem.  Debt/budget control is not something exhibited to date.

Gordon Davis Jr

Feb. 28, 2012, 11:58 p.m.

Are we really looking at a breakup of the euro, or just the exit of a country or two.  Mohamed El-Erian was on CNBC this morning and his position is that the euro can survive as long as Greece and Portugal exit.  He went on to say that he thinks that the investment outlook (equities) for the US is either really good i.e. up 20% or pretty bad as in down 10% by year end.  So what’s an investor to do?  Buy, buy, buy, but make sure you have a window seat above the 3rd floor just in case.

Andrew Fately

Feb. 28, 2012, 6:11 p.m.

I think it has become clear that there is no costless way to solve this problem.  But while the economics continue to be compelling for exit and devaluation, the article ignores what has become the only possible rationale for Europe to sork so hard to salvage the status quo, namely the political repercussions.  If the PIIGS leave the euro, every current member of the European leadership will be tarred with the failure of the euro and those countries.  It can already be seen that many polls across Europe are pointing to a lack of support for further bailouts. 

I fear that the politicians in Europe, who after all are no different than our own here in the US, care more about staying in power than solving the problems that have developed in the eurozone.  And as such, even though the evidence presented here is compelling for the periphery to exit the single currency, not one of them will be willing to attach their name to the period when the euro cracked.

As to the CDS question Chad raised, I would guess that there are two mitigating circumstances.  First, much of the CDS written is likely to have been done so by institutions outside the EU, thus reducing the impact, and second, the peripheral banks, who also engaged in the writing of CDS, are already technically insolvent.  That recapitalization is already figured as part of the process.

Andrew Johnson 35283

Feb. 28, 2012, 4:51 p.m.

Let me propose a question….

How long did it take the Europeans to create the Euro? Answer: 2 years and a mountain of software engineers to get the Euro up and running across all member states.

Have you heard any rumblings about the Drachma being reintroduced to Greece or a mountain of software engineers preparing to reintroduce the Drachma into the Greek economy?

Answer: You have not.

Conclusion, sovereign accounting is unlike business or financial accounting. Sovereigns can do whatever they want due to seigniorage. Now the case for seigniorage is a bit different pertaining to the Euro zone because the ECB is effectively a foreign central bank.

You are going to be sorely disappointed about what the Euro outcome is going to be. It will result in a stronger federalist Euro rather than a smaller euro core. Sure maybe Greece will exit but it won’t be like you think.

Chad Ericson

Feb. 28, 2012, 4:13 p.m.

This is a good synopsis of a roadmap the PIIGS could follow in a euro exit.  I have not read the full report, but I find it interesting that CDS are not addressed in the condensed version.  If a number of countries simultaneously exit the euro and default, the CDS will most certainly have to be paid out.  Germany and the EU leadership most likely do not want a CDS event.  This is evidenced by their continued support of the highly levered euro zone countries. The LTRO has calmed the waters for the time being, and we may get 500 billion more in the LTRO tomorrow.  This will help the banks, but if there are a number of defaults in succession it may be too much for the counter parties (banks) of the CDS can take.

One has to ask, what were the levels of CDS that were paid out in 2002 in Argentina (most recent currency departure)?  Probably nowhere near the levels of the CDS involved in the PIIGS situation.  If these countries exit the EU they are forced into default on their sovereign debt.  CDS will pay out no matter what Merkel and EU leaders have to say about it.

All of a sudden you are back to United States like 2008 problem.  The banking system in Europe will be broken and they don’t have enough money to make everyone involved whole again.  There are no easy solutionsâ?¦

Ski Milburn

Feb. 28, 2012, 3:28 p.m.

This article makes clear something that should have been known for some time now, that countries can exit monetary unions, that many have in the past, and that while traumatic, the process is well understood, can be followed, and results in better outcomes for the countries in crisis.

What isn’t discussed is the likely catastrophic effects on the German economy, who have moralized endlessly on the “lazy debt-ridden peripheral barbarians” without recognizing how much of their economic boom has been driven by the depressed value of the Euro, which will surely rise when they exit. 

It would actually be cheaper for the Germans to just give the PIIGS the money to get their debt down to sustainable levels than what’s going to happen next, but it wouldn’t solve the fundamental structural problems of the Eurozone.

And this whole mess comes right back to John’s Debt Supercycle thesis.  We’ve been infatuated with debt for several decades now, borrowers thinking it was a free ride (to be paid out of the proceeds of future growth and prosperity) and lenders thinking that they liked creditor rights and the sanctity of contracts better than the diffuse risks of equity ownership. 

Both are about to find out how wrong they were, but of the two, its the lenders that are going to get whacked the worst.  In the end, most of the Sturm and Drang on the international stage (not to mention the bank bailouts and tea party response in the US) is about the large lenders using their political access to try and wring blood out of turnip, or at least save their own skin.  Good luck with that.

Jerry Lobdill

Feb. 28, 2012, 11:31 a.m.

Another fine article!  I appreciate these insights from an economic stratum that I don’t inhabit. If you saw the movie “Help”, I consider myself among the lower level folks.  My interests in economics are concerned with how money could be made to serve all its functions without exploiting any of them.

I never thought the euro was going to work. I discussed this at length on several www discussion groups inhabited by like-minded people. I also had a private discussion with Bernard Lietaer. IMO economic stability requires that sovereign nations be in control of their own monetary policy, and the policy must serve the greater good—no special power for those with high net worth, and no ability for speculators to manipulate the economy to their advantage.  A nation whose monetary policy is set by external powers is not sovereign, and its people are doomed to be exploited for the betterment of those who are always wanting to destabilize and profit.

Today’s article seems to imply a low cost solution to the euro crisis is available, but the question is, who is going to pay for the devaluation? The article proposes to off-load the cost on non-speculators when it suggests the advantage of surprise changes. It seems to me that when the article speaks of low costs it is speaking about the wallets of the wealthy only.

Thanks for the opportunity to comment!