THE CREATIVE DESTRUCTION OF THE EURO

Next to the Nobel, the richest and most prestigious economic award is the £250,000 ($400,000) Wolfson Economics Prize, awarded by the Wolfson Foundation, founded by British entrepreneur and philanthropist Sir Isaac Wolfson in 1955.  It currently has an endowment of $1.2 billion.

Unlike the Nobel, the final contenders for the Wolfson are known in advance.  This year, out of 425 entrants, five were chosen as finalists – and they all have a shared nightmare on how to "manage" a full or partial disintegration of monetary union. They agree on little else.

"The consequences of a completely unplanned ‘Exit’ are likely to be catastrophic," said Neil Record from Record Currency Management, one of the five qualifiers.

Catherine Dobbs, a former algorithms expert at Gartmore, said the global shock could be five to 10 times worse than the Lehman earthquake in 2008, given the scale of contracts and counter-party exposure.

The Lehman lesson is that authorities must have contingency plans in place to stop a seizure of the global credit system. The crucial point is exactly how a break-up occurs, not whether it does so.

Mr. Record believes piecemeal exits by one country at a time – the most likely outcome on current policy settings – would be "a recipe for continuous crisis." There can be no such half-way house in any case. As soon as one country leaves EMU, the euro will lose its aura of inevitability. The charisma drains away.

Thus Mr. Record advocates a secret German-led "Taskforce", with a French cameo role for the sake of "legitimacy." Any broader planning would leak. The European Central Bank and the European Commission would be kept in the dark since they are "not well-equipped to design the demise of their own ‘great project’."

"Failure to maintain secrecy would almost certainly lead to a complete freeze in the markets, making it impossible to finance eurozone member states’ deficits. This could accelerate a vicious circle … and possibly overwhelm the ECB. This is the stuff of nightmare," he wrote.

The Taskforce would drop its bombshell on EU leaders on a Saturday morning. There would be a return to national currencies the same day. Any attempt to preserve a core euro would be unworkable since complex contracts worth hundreds of billions would leave a legacy of "ruinous litigation", he said.

The only option would be to "force the legal frustration of all outstanding euro contracts" by abolishing the currency altogether. This would wipe the slate clean.

North European banks would face a brutal devaluation of Club Med debt. They would have to be recapitalized by their governments. The ECB would be shut down, with power reverting to national capitals.

Such a framework would allow Europe to "prosper again." Foreign exchange markets would adjust "very quickly" once the boil was lanced. "Exit could start a new vibrant period in Europe’s history," he said.

Any attempt to hold the project together against economic logic by scorched earth policies would ultimately entail costs "many times greater."

Jens Nordvig and Nick Firoozye from Nomura said that once the first state leaves EMU there will be a chain-reaction to Spain or Italy, causing havoc for currency swap contracts, and interest rate derivatives. "We believe that even if a break-up begins to unfold in an ‘onion-peeling’ fashion, it will eventually spin out of control and turn into a ‘big-bank’ break-up of the eurozone. An Italian default and exit would likely bring down large parts of the eurozone banking system."

French banks would buckle, setting off a crisis that would push French public debt towards 120% of GDP. "Capital controls would be a distinct possibility, at which point the euro would be obsolete."

Mr. Nordvig said policy makers must face the hard truth since credit markets are already pricing in a 30% chance of Italy defaulting:

"Euro adoption was supposed to be ‘irrevocable’, but the genie is out of the bottle. Foreign investors around the world, as well as institutions within the EU, are already trying to make contingency plans for a eurozone break-up. There is even evidence that some regulators outside the eurozone are asking banks to submit contingency plans for various eurozone break-up scenarios. Against this background, the cost-benefit analysis of planning ahead versus pretending that a break-up is not possible has shifted."

EU leaders must spell out contingency plans right now to calm investors, above all by clarifying the jurisdiction of €14.2 trillion of debt. There should be a new European Currency Unit (ECU-20) ready to redenominate assets if needed, according to Mr. Nordvig.

Mrs. Dobbs proposed a variant of this, calling for a new settlement currency if the bloc splits into a hard core and weak periphery. Old euros and euro contracts would be treated equally. "There will be no impact on the solvency of financial institutions that have euro-denominated assets and liabilities that are unmatched," she said.

Jonathan Tepper from Variant Perception said the eurozone is operating in the same destructive way as the 1930s Gold Standard, forcing the full burden of adjustment on the weaker countries. They are "condemned to contraction or low growth" with overvalued exchange rates as long as they remain in the euro.

Exit is the cleanest way to "re-balance Europe" and end the deflationary bias in the system. This may mean "crystallizing losses" but they already exist in any case.

Mr. Tepper said there have been at least 100 currency break-ups or exits over the past century, including the Austro-Hungarian union (the closest parallel), and Soviet, Czechoslovak, and Indian unions. They offer a roadmap of orderly divorce. The experience can be quick and liberating.

Devaluation episodes in Asia (1997), Russia (1998) and Argentina (2002) show the pain is sharp but short, followed by growth within two to four quarters. Dire warnings proved wrong in each case. Argentina rocketed back with 26% growth over the next three years.

Mr. Tepper disputes the validity of the Lehman parallel, so long as dissolution is planned. While the euro is sui generis – and huge cross-border capital flows have raised the stakes – the EMU debacle is no more than an emerging market crisis writ large. 

The net external indebtedness of Greece, Portugal, Ireland and Spain is almost 100% of GDP, or more than 30% worse than in the Asian crisis. The "cure" of exits, defaults and devaluations is even more urgent.

Unilateral exit states would spring a "Saturday surprise," suddenly reverting to the Drachma, Escudo, etc. Euro notes would be stamped with national insignia. Capital controls would be imposed, with a bank holiday.

Local jurisdiction debt would be switched to the new currency under Lex Monetae. More than 90% of Greek, Portuguese and Spanish state debt is under national law.

The Germans, French and British would be left "holding the bag." They would have to be recapitalized (again) with public funds. The ECB would be technically insolvent. Life would go on.

The fifth contender is Roger Bootle of Capital Economics, who argues that "The euro is a malfunctioning monetary union that was put together for political reasons. It is a currency in search of a government."  It must be abandoned with "a combination of currency redenomination and devaluation" – preparations for which must be coordinated in secret.

In sum, the Wolfon gurus see the break-up of the euro as necessary, dangerous, and possibly liberating.  A disorderly break-up would set off a cataclysmic chain-reaction and collapse of Europe’s banking system, pushing the world into full-blown depression.

Mr. Bootle, however, thinks an orderly break-up is possible with a minimum of pain.  "If handled well, euro exit could present weak peripheral members with a much better prospect than remaining in the euro. Moreover, their exit could enhance the prosperity of the rest of Europe – and the wider world."

The Wolfson Economics Prize will be awarded in July.  Will the euro last until then?

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.