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The end of EMU: legal ramifications

Julian D. A. Wiseman

Abstract: In early 2000 an investor asked me how EMU could break up, and what would be the legal consequences. This essay explains.

Contents: Introduction, Lex Monetae, How to gate-crash EMU, How to leave EMU, What happens to existing euro debts?, Swaps, Conclusion, Footnotes *1 *2 *3.

Publication history: only here. Usual disclaimer and copyright terms apply.


At the start of January 1999 eleven countries*1 merged their currencies into the euro. This merger is described by the European authorities as ‘irrevocable’. But the nature of this irrevocability is widely misunderstood; by the public, by the press (at least in the UK), and even by some central bankers (who really should know better).

There are 100 cents in the US dollar. US law is clear: if I owe you a 100¢, then I owe you $1. This hundred-to-one exchange rate is unbreakable. If I deposit in my bank account 1000¢, and then deposit $10, the bank does not keep a separate tally of how many dollars and how many cents I have deposited, it only knows that I have $20.

And if the US government were change the dollar/cent exchange rate, the financial system would be in ruins. Depositors would insist that they had deposited money in the more valuable form, borrowers would insist that they had borrowed the less valuable form. Banks would become insolvent, triggering a collapse in lending and a major depression: the economic damage would be huge.

Note that these ‘two currencies’ (US dollars and US cents, with ISO codes USD and USX) have different physical forms. Dollars come in the form of white paper marked green, cents in the form of coins. The difference in the physical manifestations makes no difference: the exchange rate between the two is fixed.

This is most clearly illustrated by the decimalisation of the pound in February 1971. The UK government did not change the number of pennies in the pound. Rather, it introduced a new currency, the ‘new penny’, worth 2.4 old pennies, so that 1 pound equalled 100 new pennies (equalled 240 old pennies equalled 20 shillings equalled 960 farthings). Obligations in the old pennies were translated into the new at the exchange rate of 2.4-to-1: thus a debt of 12 old pennies was replaced by a debt of 5 new pence. (A paper by the EU authorities discusses the lessons that decimalisation holds for the euro, and a brief history can be found here.)

Under European law, and the law of the countries of the EU, the euro is no different. It too comes in various denominations, including the euro cent (at an ‘exchange rate’ of 100-to-1), the Deutschmark (at an exchange rate of 1.95583-to-1), the French franc (6.55957-to-1), the guilder (2.20371-to-1), etc*2. Just as with the US dollar and cent or the British pound and penny, these denominations have different physical manifestations, both paper and coin. Just as the dollars in an bank account might have originated with dollars or with cents, the euros in a bank account might have originated with any combination, positive or negative, of the euro’s predecessor the ECU, the euro cent, the Deutschmark, the French franc, the guilder, and so on. In practice it would be impossible to ‘unstir’ the US dollars and US cents in a US bank account; and it would be impossible to ‘unstir’ the various payments in Deutschmarks, French francs, etc that make a euro bank balance.

So much for European law; what about contracts under non-EU jurisdictions? What happens to a Deutschmark debt under (say) the law of Texas? There is a guiding legal principle, called lex monetae, which says that jurisdictions determine their own currency. In summary, for enforcement of an English-law debt of some units of Canadian currency, English law looks to Canadian law to define that currency. The following ¶ is taken from the website. (Alternative source: European Parliament.)

The application of the principle of “lex monetae” or the “state theory of money”, which is a universally accepted principle of law, should ensure the continuity of existing contracts also in third countries’ jurisdictions. As set out by F.A. Mann (“The Legal Aspect of Money”, 5th ed.), it is the law of the currency (“lex monetae”) that determines how in case of a currency alteration, sums expressed in the former currency are to be converted into the new one. The underlying assumption is that money as a legal construction is subject to the power of the State. It is held that each State exercises its sovereign power over its own currency, and that no State can legislate to affect another country’s currency. From this it follows that it must be the law of the currency which determines what is money and what nominal value is attributed to it. Applied to the introduction of the euro this means that in non-EU jurisdictions which respect the principle of “lex monetae”, references in contracts set up in the currency of a participating Member State will be interpreted with reference to European law, which is directly applicable in each of the participating Member States. To ensure the recurrent link between the euro and the national currencies, the Council Regulation on the introduction of the euro stipulates in Article 3 that “the euro shall be substituted for the currency of each participating Member State at the conversion rate”. (The “recurrent link” between a currency and its predecessor defines the value of a currency unit of a new currency in terms of the number of units of the former currency.) Moreover, Article 3 of the Council Regulation (EC) No 1103/97 confirms the principle of continuity of contracts and other legal instruments. European Commission contacts with third countries’ governments and market participants have shown that the principle of “lex monetae” or the “state theory of money” is indeed followed in the main financial centres of the world.

So, in jurisdictions which respect the principle of lex monetae (which might not include the likes of North Korea, but are believed to include all the jurisdictions relevant to financial markets), a debt of 100 cents is payable in the form of 1 dollar, and a debt of of 1.95583 Deutschmarks is payable in the form of 1 euro. And in these same jurisdictions, money balances have become ‘stirred together’ (dollars and cents, Deutschmarks and French francs), and are no longer be separable.

Indeed, this unstirrability applies not only to money, but also to government debt. For example, at the end of January 1998 Portugal issued just over 40.5 billion escudos of a 5.375% bond maturing on 23rd June 2008 (code PTOTEBOE0012). The following month it sold a FRF-denominated bond, also with a coupon of 5.375% and also maturing 23rd June 2008 (XS0084486710); and then a DEM-denominated same-coupon same-maturity bond (XS0084487106). Reopenings brought the sizes of these three separate securities to almost PTE 295 billion, to FRF 4 billion, and to DEM 1 billion. At the start of EMU these three currencies became one, and the three securities merged into a single bond of size just under EUR 2.6 billion. Investors’ holdings of these three securities became blended together. For example, an investor who bought PTE 15 billion, FRF 100 million, and DEM 20 million of these three securities had these holdings combined into a single holding of size just under EUR 100.29 million. Assume now that the investor then sold EUR 100 million exactly, leaving a remaining holding of size about EUR 290 thousand. If there were now an attempt to separate the old Deutschmark from the euro, what would happen to this investor’s holding? Would the investor owe to the issuer some of the newly-separated DEM bond? Of course, there is nothing sensible that could be done: the old Deutschmark has been irretrievable stirred in with the ECU, the euro, and the other national currency units. Even Canute knew that he could not turn back the tide.

EMU is a one way door. Indeed, the door is so one-way that even gate-crashers cannot be evicted. Imagine for a moment that Poland wanted to join EMU, at a rate of EUR 1 = PLN 4. Can it do this without European permission? Yes. M0 (loosely speaking, the amount of money issued by the Polish Central Bank) is about PLN 48 billion: if Poland had at least EUR 12 billion of foreign-exchange reserves, it could gate-crash. Two steps would be needed. Firstly, Poland would legislate that the EUR replaces the PLN at a rate of 1-for-4. Lex monetae ensures that this replacement is recognised by non-Polish jurisdictions. Second, Poland would deliver its EUR 12 billion of reserves to the European Central Bank, and withdraw the same value of EUR banknotes. (If this were done before the introduction of euro banknotes, it would take the reserves to the Bundesbank and withdraw Deutschmark banknotes — for these purposes no different.) These banknotes would be transported to Poland, and existing zloty notes would be exchanged for euro (or Deutschmark) notes. There is nothing that the ECB could do to prevent this, and it would not be possible for Poland to leave or be evicted: entry into EMU is truly a one-way door. (Of course, being invited to join EMU is better than crashing, because invited countries have a formal position and vote within the ECB.)

Indeed, during 1999 Argentina was reported to be considering a unilateral dollarisation, to be performed in a similar manner. Had it decided to proceed, the Federal Reserve could not have prevented it.

The above does not mean that this EMU must last forever. It just means that the old Deutschmark, the old French franc, and the others, are irrecoverable.

So how can EMU end?

Let us say that, for whatever reason or reasons, Germany wished to leave EMU. How could it be done? Germany could introduce a new currency, and declare it to be the only legal tender within German jurisdiction. To encourage the use of new currency, Germany might make taxes payable in the new currency, and might make the new currency mandatory for certain forms of contract. This new currency would be entirely under the control of the German authorities, and they might or might not choose to delegate this control in whole or in part to an independent central bank.

Alternatively, Germany could make a different currency legal tender, perhaps the dollar or the pound or the Swiss franc. For the purposes of this exposition the effect would be similar.

So far, so easy. But would happen to existing euro-denominated debts?

This question might be irrelevant. In January 1921 a German newspaper cost 0.3 marks; by the end of 1922 it cost 70 million marks. A repeat of such a hyperinflation would make a debt of several hundred million euros so small as to not be worth the squabble. Of course, inflation is now below 2%, so manic devaluation of money now seems unlikely — but equally a German departure from the euro zone now seems unlikely. But if we assume a German departure, hyperinflation becomes a probable reason.

In any event, whether or not there has been hyperinflation, a departing country has only one sensible course of action. Outstanding euro obligations should continue to be payable in euro. This would be in the economic interests of the departing country, of those remaining in the euro zone, and of those countries that never joined.

The alternative is disastrous. We have seen above that obligations in the likes of ECU, DEM, FRF, and the others are ‘stirred’ together. A departing country might be able to convert some euro debts into its new currency — possible methods are discussed below — but it cannot convert all.

Converting some would cause mass insolvency amongst financial institutions. Consider the (somewhat simplified) position of a bank, with which a total of ten billion euros has been deposited, and which has in turn lent these ten billion euros to customers and to other financial institutions. Now have some of these obligations converted into a new more valuable currency. If the bank’s assets (its loans to others) were converted, it would have a windfall profit (and therefore a windfall loss for someone else). If its liabilities are converted (others’ deposits with it), a loss, and perhaps bankruptcy, would follow. Such a partial ‘un-euro-isation’ would near-randomly redistribute wealth, collapsing many financial institutions.

But what if a government still wanted to enforce euro debts in its new currency. Could it do so? The answer is that it could try, and not totally fail.

Recall that we were considering the case where a large EMU member, say Germany, quits EMU. German legislation has complete control over contracts governed by German law. It is within the power of a government to pass a law making debts payable in the new currency (at some legislated exchange rate); or cancelling all debts, or selectively cancelling debts, or re-denominating debts owed to or by certain groups of people. (This is not unknown: the Nazis proposed a similar selective non-enforceability of German-law insurance contracts, though were persuaded otherwise by the insurers.) The point is that German law has total control over contracts enforceable under German law.

Of course, if Germany were to leave, France may well follow. And French legislators could choose what happens to French-law contracts — and that thing might not be the same thing as happens to German-law contracts.

However, German influence over debts enforceable in other jurisdictions (such as England & Wales, New York, and Japan) would be slight. So long as the euro exists (even if only as the currency of the city of Brussels), euros debts payable under the law of the jurisdictions would remain in euro. But what about Deutschmark debts? Currently, in enforcing a Deutschmark debt in (say) Japan, Japan looks to German law to define the Deutschmark, and German law says that the DEM is one part in 1.95583 of a EUR. But what if German law ceased to say that? What would Japanese law then say?

Japanese law might say that the debt had been converted into euro, and so lex monetae should no longer look to German law, but to European law. This ruling would be more likely if the debt had been converted into euro with the agreement of the parties, perhaps by being mixed with other eurozone currencies, and appearing in euros on a ‘statement’ or other written correspondence.

Alternatively, Japanese law might say that a Deutschmark debt remains a Deutschmark debt, even though it was for a while (but is no longer) repayable in euros, and therefore that German law should determine the form in which it is now to be paid.

To assist the confusion, a court in Tokyo might rule differently from one in London or in New York. In any event, it seems likely that the jurisdictions whose law governs most financial transactions would legislate to ensure ‘once in euro, always in euro’.

Swap transactions

(For this part of the essay, it is assumed that the reader has at least a basic understanding of interest rate swaps.)

In 1998, new swaps were being transacted against LIBOR in any of ECU, DEM, FRF, ITL, ESP, NLG, and PTE (LIBOR is the London Inter-Bank Offered Rate, and is computed by the British Bankers’ Association). New swaps were also being transacted against FIBOR (the cost of borrowing DEM in Frankfurt, computed by the German Bankers’ Association), PIBOR (FRF in Paris), RIBOR (ITL in Rome), MIBOR (ESP in Madrid), AIBOR (NLG in Amsterdam), BIBOR (BEF in Belgium), HELIBOR (FIM in Helsinki), VIBOR (ATS in Vienna), DIBOR (IEP in Dublin), and others.

EMU brought on a simplification. There are no longer separate London ‘fixings’ of ECU, DEM, FRF, ITL, ESP, NLG, and PTE: there is one fixing of the cost of EUR money in London, and this is copied across for the other currencies. On the continent, the European Banking Federation has created a eurozone fixing called Euribor. And (for example), the German Bankers’ Association no longer fixes the cost of borrowing DEM in Frankfurt; instead it has specified that the FIBOR fixing shall be equal to the Euribor fixing.

For the most part, this has worked smoothly. (The one exception is that the French Bankers’ Association messed up the transition from FRF PIBOR to Euribor*3.)

Consider the position of two parties who have traded a BIBOR swap (the former Belgium-franc fixing), using German-law documentation. This swap is, well, whatever German law says it is. And it settles against, well, whatever the Belgium Banking Association says it does. Of course, for now and the foreseeable future, each jurisdiction’s law says that swaps are properly enforceable, and the various eurozone national banking associations say that their national IBORs have been properly succeeded by Euribor (with a modest exception for the French mess-up). But if either of these countries leave EMU, legal uncertainty would surely increase.


1. The old national currencies are irrecoverable. For good or for ill, Germany cannot recover the old Deutschmark — it has been too stirred up with the other national currencies.

2. A nation can leave EMU, by introducing a new currency. In doing so, it can leave euro obligations to be paid in euro, or it can cause varying degrees of trouble by doing something different.

3. Because governments have a lot of power over their legal jurisdictions, and over the legal definition of their own currency, both past and present, and over the definition of their former national ‘IBOR’, a government that wanted to cause trouble could cause a lot of it.

Julian D. A. Wiseman, February 2000


*1 The eleven are Germany, France, Italy, Spain, Netherlands, Belgium, Austria, Finland, Portugal, Ireland and Luxembourg. Also in this monetary union, but not counted as part of the ‘eleven’, are the likes of Andorra, Monaco, San Marino and Vatican City.

*2 EUR 1 = XEU 1 = DEM 1.95583 = FRF 6.55957 = ITL 1936.27 = ESP 166.386 = NLG 2.20371 = BEF 40.3399 = ATS 13.7603 = FIM 5.94573 = PTE 200.482 = IEP .787564 = LUF 40.3399 = ADP 166.386

*3 PIBOR used to settle T+1. So if money was borrowed today for three months, the money would arrive on the business day after the trade date, and be repaid three months after receiving it. Euribor is T+2: money arrives the two business days after trading. The logical thing would have been for the French Bankers’ Association to say that a day’s PIBOR fixing is equal to the previous business day’s Euribor fixing, so that the old PIBOR fixing and the new Euribor fixing always span the same period of time. However, for ‘simplicity’, the French decided that today’s PIBOR fixing is to be today’s Euribor fixing. So, if you had traded a swap that was to fix against 3-month PIBOR on 29 September 1999, you might have thought that you were trading the cost of borrowing money from 30 September 1999 to 30 December 1999. But the rules by which PIBOR rolled into Euribor changed this to the cost of borrowing money from 01 October 1999 to 04 January 2000; changing the fixing from one that didn’t cover the turn-of-the-century weekend, to one that did. That made a big difference, and it seems that the whole sorry business is to end in court. (This problem was predicted in advance by William Porter of LEDR.)

Postscript added May 2000. On 27th May 2000 Romano Prodi, the President of the European Commission, gave an interview to The Spectator (a British political magazine), in which he claimed that one could join the euro temporarily, and then return to one’s old currency. This is manifest nonsense, and dishonest manifest nonsense at that.

PPS. Also see the later essays, The end of EMU: How Germany Might Leave (dated October 2000), which discusses a mechanism by which Germany could leave EMU without breaching the Maastricht Treaty, and The end of EMU: How the Germans could leave (dated March 2001), which discusses how a private-sector company could take Germany out of EMU.

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