The euro: coming of age or coming apart?

It's about time that investors start considering what might happen if the euro fell apart. There is no denying the serious cracks that opened up in Europe during 2003. Europe's internal fractures suggest that the vision of a United States of Europe may remain a pipedream.

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Disunity could lead to accelerated reforms. To be sure, a Disunited States of Europe may be just what the doctor ordered for Europe's ailing economy. Countries pursuing the right tax, welfare and labor market policies will be rewarded with capital inflows and stronger growth. Eventually, a competitive process of dynamic benchmarking should result in a less regulated and stronger economy.

But a disunited EU has other important consequences for financial markets. The country factor is likely to become more important in determining bond and possibly equity prices. Growing divisions on budgetary policy could significantly widen government bond yield spreads between the more and the less virtuous countries.

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Also, a disunited Europe would likely lead to increased political pressures on the ECB to create higher inflation. Even the most independent central banks are not immune to the political environment.

Leaving the EMU would be costly both politically and economically for the seceding country. Most important, currency redenomination would not easily apply to cross-border contracts. Foreign creditors could demand that contracts be honored in euros. Thus, if a country wanted to introduce a new currency in order to depreciate it against the euro, it would face rising foreign debt servicing costs. A country might still conclude that the benefits of reintroducing a national currency outweigh the costs. Suppose, for example, that the "stability consensus" within Europe weakens further. If so, a country with a high preference for price stability, say Germany, might conclude that it wants to introduce a new Deutsche mark that would be internally more stable and externally stronger than the euro.

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Moreover, the technical and practical hurdles for reintroducing a national currency are lower than generally presumed. First, the national central banks still exist and are fully operational. Second, the bulk of the reserves still reside with the national central banks. Third, payment systems in the euro area are still national.

Fourth, even the euro notes and coins have been issued by the 12 national central banks, not the ECB, and can still be easily traced to their national origin. If a country wants to reintroduce a national currency, it could simply use its existing euro notes and coins as legal tender until the new national money has been minted and printed.

I would not be surprised if the euro traded significantly lower and euro-zone bond yields significantly higher in 6-12 months' time as these risks are discounted in the financial markets.

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Joachim Fels, Economist

This is an edited and updated excerpt from "Euro Wreckage?" by Joachim Fels, dated January 22, 2004. For a copy of the full article, including important information and disclosures regarding Morgan Stanley, please see www.morganstanley.com/ourviews or contact 1-800-962-1343. This article does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. It was based on public information, and Morgan Stanley makes no representation that it is accurate or complete. Estimates of future performance are based on assumptions that may not be realized. Investments and services are offered through Morgan Stanley & Co. Incorporated, member SIPC. Morgan Stanley and One Client At A Time are service marks of Morgan Stanley. [c] 2004 Morgan Stanley.