Euro to Sink if Greece Leaves? Not So Fast ...

| About: CurrencyShares Euro (FXE)

A cursory look at the trade in the euro on Friday tells a predictable headline theme: The euro sinking on fears of a European breakup. But a headline rarely tells the whole story, and while it might be easy to jump to conclusions about Greece fears and the coincidental euro weakness, the idea that the euro is going to plummet if Greece abandons the common currency doesn’t make much theoretical sense ... unless you believe it would result in an overall collapse of the EMU. In fact, even if Portugal and Ireland were to follow Greece out the door, there is good theoretical reason to believe the euro might emerge a stronger and ultimately more valuable currency.

To be sure, Greece leaving the euro zone is going to spur fear-mongering over a collapse of the European Monetary Union in the short term. But Greece, Portugal, and Ireland have always been peripheral members of the EMU. They are not historically important to the creation of the EMU, and by size, they are relatively unimportant to the economic strength of the EU. Together, the "PIG" countries comprise roughly 8% of the population of the 17 euro zone countries and made up 6.2% of euro zone GDP in 2009. The loss of any one of these countries, or indeed all three, is not likely to cause a meaningful reduction in the amount of trade being conducted in euros, and it seems unlikely that Germany and France would abandon their commitment to the euro on the basis the currency being abandoned at the periphery.

Instead, a post-crisis euro might in fact look stronger for several reasons. First, the quantitative easing by another name being pursued under the European Financial Stability Fund would likely be replaced by debt restructuring, limiting expected future increases in the European money supply. Additionally, with the ECB freed from the constraint of having to promote employment and growth in the weak peripheral economies, there would be significantly more room for interest rate increases to fight inflation.

With the weak economies able to reflate their own economies by devaluation, there would seem little reason for the ECB to maintain negative short term real interest rates in the face of accelerating inflation and solid growth in the core euro zone countries. ECB officials have already been taking a more hawkish tone than the Federal Reserve, leading the euro on its upward march toward multi-year highs earlier last week. It is no secret that European monetary authorities would like to normalize monetary policy soon, and shedding the weak peripheral economies might just give them the opportunity to do so. If the interest rate differential between the euro and the dollar increases further as a result of an ECB rate hike, there will most likely be another leg higher for the euro as funds flow from dollars to euros in search of yield.

While the Greece story will continue to make headlines and probably drive up the risk premium in the euro (i.e., weaker euro) in the short term, the long term impact of a smaller euro zone isn’t as straightforward as the headlines make it seem. As always, the currency markets are subject to a number of cross-currents, and Friday’s drop in the euro was more plausibly caused by the perceived economic strength in the U.S. on the back of a strong employment report. While the recent employment trends in the U.S. will be enough to convince the Fed not to renew QE2, there still seems little stomach among Fed officials to fight inflation in the face of tepid economic growth.

By contrast, the Europeans seem very uncomfortable with current interest rate policy and ready to raise rates at the earliest opportunity. A coordinated debt restructuring and trimming down of the euro zone might just provide that opportunity by shifting the burden of supporting peripheral economies to the national central banks. The euro that would be left behind would be backed by an ECB with significant inflation-fighting credibility offset by a small loss of market size. Given the state of global monetary affairs, it is hard to see how this could be viewed as a weakness while everyone else is racing to the bottom.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.