If a messy default is forced upon a euro-zone country, it might be tempted to reinvent its own currency. Indeed, it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social unrest, high borrowing costs and banking chaos seem likely either way.
The prospect that one country might break its ties to the euro, voluntarily or not, would cause widespread bank runs in other weak economies. Depositors would rush to get their savings out of the country to pre-empt a forced conversion to a new, weaker currency. Governments would have to impose limits on bank withdrawals or close banks temporarily. Capital controls and even travel restrictions would be needed to stanch the bleeding of money from the economy. Such restrictions would slow the circulation of money around the economy, deepening the recession.
External sources of credit would dry up because foreign investors, banks and companies would fear that their money would be trapped. A government cut off from capital-market funding would need to find other ways of bridging the gap between tax receipts and public spending. It might meet part of its obligations, including public-sector wages, by issuing small-denomination IOUs that could in turn be used to buy goods and pay bills.
When cash is scarce, such scrip is readily accepted by tradesmen. In August 2001 the Argentine province of Buenos Aires issued $90m of small bills, known as patacones, to employees as part of their pay. The bills were soon circulating freely: McDonalds even offered a “Patacombo” menu in exchange for a $5 pata c ón. Argentina broke its supposedly irrevocable currency peg to the dollar a few months later.
Scrip of this kind becomes, in effect, a proto-currency. In a stricken euro-zone country, it would change hands at a discount to the remaining euros in circulation, foreshadowing the devaluation to come. To pre-empt further capital outflows, a government would have to pass a law swiftly to say all financial dealings would henceforth be carried out in a new currency, at a one-for-one exchange rate with the euro. The new currency would then “float” (ie, sink) to a lower level against the abandoned euro. The size of that devaluation would be the extent of the country’s effective default against its creditors.Link. The Economist ends its rosy scenariising on an encouraging note: "Such a disaster can still be averted." From your mouth to God's ear.
Market gurus and other students of misaligned stock, bond or home prices often say that although it is easy to spot an asset-price bubble, it is impossible to know the event that finally pricks it. In much the same way, the likeliest trigger for a disintegration of the euro is unknowable. But there are plenty of candidates. One is a failed bond auction that forces a country into default and sends a shock wave through the European banking system. Italy has €33 billion of debt coming due in the final week of January and a further €48 billion in the last week of February (see chart 3). Since bond investors are turning their noses up even at offerings from thrifty Germany, the odds against Italy’s being able to raise the money it needs early next year are uncomfortably short.
Another danger is a disagreement between Greece and its trio of rescuers (the EU, the IMF and the ECB) over the conditions of its bail-out. The risk of a mishap will be greater after the Greek elections in February if the country’s political mood sours yet further. Perhaps the spark will come from another source: the bankruptcy of a bank; fresh trouble in Portugal; or a chain of events that starts with France losing its AAA rating and ends with runs on banks across Europe. The exposure of French banks to Italy and to other countries that have been in bond traders’ sights for longer implies that contagion would quickly spread to the euro’s core (see chart 4). Widespread defaults in the periphery would wipe out a big chunk of Germany’s wealth and begin a chain of bank failures that could turn recession into depression.
The few left in the euro (Germany and perhaps a few other creditor countries) would be at a competitive disadvantage to the new cheaper currencies on their doorstep. As well as imposing capital controls, countries might retreat towards autarky, by raising retaliatory tariffs. The survival of the European single market and of the EU itself would then be under threat.