What if the euro fails?
When the European sovereign debt crisis began in late 2009, few experts believed it would bring about the demise of the euro, a currency used by 17 of the 27 European Union countries. But today, with a steady stream of bad news coming from Europe, speculation has grown — at least in some circles — that the euro’s days might be numbered or at least that a handful of the most troubled countries like Greece might exit the euro and use their own currency going forward.
“The likelihood of a full-scale collapse of the euro remains very remote,” says Werner Bonadurer, a clinical professor of finance at the W.P. Carey School of Business at Arizona State University in Tempe, Ariz. “But the impossible has become possible, and it is necessary to think about the unthinkable.”
Preparing for the unthinkable
Taken as a whole, Europe represents America’s largest trading partner. “The most common currency for transactions between U.S. and European businesses is the dollar,” says James Sagner, associate professor in the School of Business at the University of Bridgeport in Connecticut. “But the euro is a close second, and that leaves anyone doing business with Europe very exposed.”
Part of the problem is that uncertainty about the euro’s future is driving the currency’s value down relative to the dollar, Sagner says. Currently, the euro is trading near its 52-week low, and many economists believe the dollar and euro may eventually trade at a 1-to-1 ratio.
“If you made a deal to be paid in euros, you’re losing money right now,” Sagner says.
Going forward, you have a few options. First, American businesses can always write contracts that specify payment in dollars. Or, those companies can buy so-called forward contract, which lock in a future price for the euro, he says.
“You’ll pay a little more for a forward contract, but if the price drops dramatically, you won’t be affected,” Sagner says. “(As is), small- and medium-sized businesses don’t have experience with forward contracts, and you generally find that only the larger banks even offer the product.”
What happens next?
“There are a lot of possible scenarios,” says David Song, a currency analyst for DailyFX in New York. “None of them are very good.”
Broadly speaking, the euro faces several possibilities.
A total collapse, which experts like Bonadurer stress is remote, could trigger a far-reaching catastrophe.
“Such a collapse would lead to a multiyear depression in Europe and several years of recession in the U.S.,” Bonadurer says.
But it wouldn’t be a typical recession in the U.S., says Terry Connelly, dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco.
“Collapse of the euro would have a worse impact on the U.S. economy than the Great Recession because it would produce an even greater one worldwide,” Connelly says. “A rush of financial assets out of the eurozone would play havoc with currencies and the price of oil.”
Even worse, Connelly predicts a collapse also could destroy interbank lending worldwide. A run on banks around the world would freeze credit markets, making it difficult for businesses to borrow money. But unlike a similar crisis in the U.S. in 2008, Connelly says “there really is no road map” for saving the global banking industry because there’s no single global entity that wields as much power internationally as the U.S. Federal Reserve does domestically.
Much less catastrophic and much more likely is a scenario in which some of the weaker eurozone countries such as Greece and Portugal exit the euro. It’s a scenario Sagner calls “manageable.”
But countries that continue to use the euro will pay a price, says Bonadurer, who estimates that even a “small-scale breakup” could destroy from 25 percent to 60 percent of gross domestic product in the stronger countries that remain with the euro.
“Banks throughout Europe and to some extent elsewhere would suffer catastrophic losses and would need to be nationalized,” Bonadurer says. “There would be massive wealth destruction in the private sector. European export markets for (the stronger EU countries) would practically disappear because devaluation will make those products and services expensive and uncompetitive, and we would see huge unemployment as a result.”
What about a new currency?
When the euro was created, there were no contingency plans for a country like Greece exiting the euro. But if that exit occurs, Greece will need to set up a new currency.
“Countries converted into the euro, so they ought to be able to convert out,” Sagner says. “But how they go about doing that can be a very complex question.”
Greece would need to decide on a name for its new currency and print and issue notes. But beyond the daunting logistics of implementing a new currency, Sagner says the Greek government also would have to revalue assets in the new currency. “That’s where things could get ugly,” Sagner says. “If a new Greek currency were allowed to trade against other currencies, you could see it losing about half its value.”
In the meantime
Song remains optimistic that EU action will eventually quell market fears and preserve both the EU and the euro, at least for some countries. But the turbulence surrounding the crisis already has had a negative effect around the world.
“Whatever you think of the euro, the possibility that it might collapse, or even speculation about its collapse, is going to work against economic growth in Europe and our own economic recovery,” Song says.
For Americans eyeing their 401(k)s and other investments, the wave of unpredictable news will hurt their bottom line, if it hasn’t already, says Tony Zabiegala, vice president of Strategic Wealth Partners in Seven Hills, Ohio.
“If there is continued market volatility and no feasible solutions, stock market volatility around the world will continue,” Zabiegala says. He adds that prolonged ups and downs also may weigh heavily on U.S. consumers who might be hesitant to spend money in the face of economic uncertainty.
But Americans don’t have to passively watch their investments disappear with each market swing, says Mike McGervey, president of McGervey Wealth Management in North Canton, Ohio.
McGervey advises sophisticated investors to adjust to a less-aggressive portfolio and minimize exposure to Europe and to the U.S. financial industry, which is itself somewhat exposed to trouble in Europe. Less-sophisticated investors can check with their mutual fund company about their exposure to Europe.
“Some people might think that there’s no difference between an aggressive portfolio and a moderate or conservative one because they all go down,” McGervey says. “But really, it’s a question of how much you lose at a time like this. The important thing is that consumers take action before the crisis, not after. (In 2008) a lot of people waited until we had hit bottom and then they sold their portfolios, which really didn’t make any sense.”