UBS Quantifies Costs Of Euro Break Up, Warns Of Collapse Of Banking System And Civil War

Any time a major bank releases a report saying a given course of action is too costly, too prohibitive, too blonde, or simply too impossible, it is nearly guaranteed that that is precisely the course of action about to be undertaken. Which is why all non-euro skeptics are advised to shield their eyes and look away from the just released report by UBS (of surging 3 Month USD Libor rate fame) titled "Euro Break Up - The Consequences."

UBS conveniently sets up the straw man as follows: "Under the current structure and with the current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change." So far so good. Yet where it gets scary is when UBS quantifies the actual opportunity cost to one or more countries leaving the Euro. Notably Germany. "Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade.

If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. " It also would mean the end of UBS, but we digress. Where it gets even more scary is when UBS, like many other banks to come, succumbs to the Mutual Assured Destruction trope made so popular by ole' Hank Paulson : "The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless).

It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war."

So you see: save the euro for the children, so we can avoid all out war (and UBS can continue to exist). The scariest thing, however, by far, is that for this report to have been issued, it means that Germany is now actively considering dumping the euro.

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Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries can not be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.

The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around EUR9,500 to EUR11,500 per person in the exiting country during the first year. That cost would then probably amount to EUR3,000 to EUR4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.

Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit.

The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.

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The break-up of a monetary union is a very rare event. Moreover the break-up of a monetary union with a fiat currency system (ie, paper currency) is extremely unusual. Fixed exchange rate schemes break up all the time. Monetary unions that relied on specie payments did fragment – the Latin Monetary Union of the 19th century fragmented several times – but should be thought of as more of a fixed exchange rate adjustment. Countries went on and off the gold or silver or bimetal standards, and in doing so made or broke ties with other countries’ currencies.

If we consider fiat currency monetary union fragmentation, it is fair to say that the economic circumstances that create a climate for a break-up and the economic consequences that follow from a break-up are very severe indeed. It takes enormous stress for a government to get to the point where it considers abandoning the lex monetae of a country. The disruption that would follow such a move is also going to be extreme. The costs are high – whether it is a strong or a weak country leaving – in purely monetary terms. When the unemployment consequences are factored in, it is virtually impossible to consider a break-up scenario without some serious social consequences.

With this degree of social dislocation, the historical parallels are unappealing. Past instances of monetary union break-ups 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. 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.

Even with a paucity of case studies, what evidence we have does lend credence to the political cost argument. Clearly, not all parts of a fracturing monetary union necessarily collapse into chaos. The point is not that everyone suffers, but that some part of the former monetary union is highly likely to suffer.

The fracturing of the Czech and Slovak monetary union in 1993 led to an immediate sealing of the border, capital controls and limits on bank withdrawals. This was not so much secession as destruction and substitution (the Czechoslovak currency ceased to exist entirely). Although the Czech Republic that emerged from the crisis was considered to be a free country (using the Freedom House definition), with political rights improving relative to Czechoslovakia (also considered to be a free country), Slovakia saw a deterioration in the assessment of its political rights and civil liberties, and was designated “partially free” (again, using Freedom House criteria).

Similarly the break-up of the Soviet Union saw authoritarian regimes in the resulting states. Of course, this was not a change from the previous status quo, but that is not the point. The question is not how a liberal democracy develops, but whether a liberal democracy could withstand the social turmoil that surrounds a monetary union fracturing. We lack evidence to support the idea that it could.

Even the US monetary union break-up in 1932-33 was accompanied by something close to authoritarianism. Roosevelt’s inauguration was described by a contemporary journalist as being conducted in “a beleaguered capital in wartime”, with machine guns covering the Mall. State militia were called out to deal with the reactions of local populations, unhappy at what had happened to the monetary union (and specifically their access to their banks).

Older examples are less helpful, as they tend to be more akin to fixed exchange rate regimes under a gold standard or some other international monetary arrangement. Nevertheless, the Irish separation from the UK, or the convulsions of the Latin Monetary Union in Europe (particularly around the Franco-Prussian war in 1870 and its aftermath) saw monetary unions fragment with varying degrees of violence in some parts of the union.

Writing in 1997, the Harvard economist Martin Feldstein offered a view that seems to be somewhat chillingly precognitive. He said “Uniform monetary policy and inflexible exchange rates will create conflicts whenever cyclical conditions differ among the member countries... Although a sovereign country... could in principle withdraw from the EMU, the potential trade sanctions and other pressures on such a country are likely to make membership in the EMU irreversible unless there is widespread economic dislocation in Europe or, more generally, a collapse of the peaceful coexistence within Europe.”

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Our base case for the Euro is that the monetary union will hold together, with some kind of fiscal confederation (providing automatic stabilisers to economies, not transfers to governments). This is how the US monetary union was resurrected in the 1930s. It is how the UK monetary union, and indeed the German monetary union, have held together.

But what if the disaster scenario happens? How can investors invest if they believe in a break-up, however low the probability? The simple answer is that they cannot. Investing for a break-up scenario has not guaranteed winners within the Euro area. The growth consequences are awful in any break-up scenario. The risk of civil disorder questions the rule of law, and as such basic issues such as property rights. Even those countries that avoid internal strife and divisions will likely have to use administrative controls to avoid extreme positions in their markets.

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

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Alas, this will be the final outcome. Unfortunately trillions more in taxpayer capital will be lost before we get there.

In the meantime, enjoy as UBS just unwittingly announced the final countdown for the EUR.

Someone commented in Business Insider:

This is too rich.... the Germans designed the EU and the Euro in the same way they design cars. They build them in a way that they cannot be unbuilt.

Or to make it even more precise, if you try to unbuild them, you end up destroying each and every part during the process...too bad you cannot trash the whole union and get a brand new one...that would be less expensive for everyone.

“Civil War” implies that these are no longer sovereign nations. I guess they are just provinces now.

Collapse of the Euro.
Civil War in Europe.

The unions are declaring war on half the people in the US.
The Vice President is calling us barbarians, as civilization seems to begin its intended collapse.

Just about "go time", I'd say.

4 posted on 09/05/2011 7:23:06 PM PDT by ClearCase_guy (The USSR spent itself into bankruptcy and collapsed -- and aren't we on the same path now?)

Who writes this Junk. Germany dumping Euros is like Turbo Timmy getting out of U.S. Dollar. This kind of fear is what causes runs on banks.

RE: Who writes this Junk

Would you believe it is a report from Switzerland’s largest bank? (Do they have an agenda?)

RE: Germany dumping Euros is like Turbo Timmy getting out of U.S. Dollar.

With one major exception -— Germany is increasingly being asked to carry the burden of the many insolvent European countries and their citizens are getting sick of it ( Angela Merkel’s party just lost a big regional election with the EURO as a major issue ).

Imagine the Citizens of Texas being asked to bail out the bankrupt states of New York, California, Illinois, New Jersey and Michigan simultaneously and you begin to understand how the Germans are feeling today.

If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter.

But the cost of staying in and endlessly supporting the deadbeats in Greece, Portugal, Southern Italy, Spain and so on is going to be a lot higher.

And our favorite past Senator Phil Gramm (the father of sub prime mortgages who spearheaded bank deregulation...also created the Enron Loop Hole where he wife served on both board of directors and audit committee) works at UBS. sarcs

The show “Yes, Minister” and “Yes, Prime Minister” were the two best places to have the whole “euro-ideal” explained to mere mortals:

http://www.youtube.com/watch?v=K-Xvy1r4Pm8

http://www.youtube.com/watch?v=GJyg6728ozg

Precisely that is what is going on in Europe and coincidentally within the US now between the producers and the moochers.

So Germany has a decision to make. As a leader of the EU, Germany has a lot of influence in the world. But independently, without the EU, Germany just becomes a second or third tier country.

Power is gonna cost ya. No free lunch.

When states go bankrupt, they should revert to territorial status and lose their Senators and Representatives.

Obama is terrifying the EU, they realize they are on their own. Gold at $1900 again today. Should see global stock tanking again tomorrow. Omullah speech on Thursday shall presage a final tanking down for the week on Friday on equities. Remains to be seen how low banks go without some major intervention again. Buffet already propped up GS and BAC. He can only do so much.

“Germany dumping Euros is like Turbo Timmy getting out of U.S. Dollar.”

Actually, it’s not. Germany had the DM long ago and can go back. We’ve pretty much always had the dollar. Germany is a sovereign nation, last I checked.
If the US used Ameros and changed back to the dollar it would be analogous.

As long as the Euro exist it can’t be unwound. How do you determine which Euro are better than others.

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