FROM THE ECONOMIST INTELLIGENCE UNIT
Efforts to preserve the euro zone and its common currency have intensified in the past month—witness the summit in Brussels on December 8th-9th, which led to support for a “fiscal compact” to improve budget discipline. That said, the Economist Intelligence Unit continues to attach a 40% probability to the break-up of the euro area in the next two years. Were that to happen, the implications for countries and companies in the euro zone and globally would be severe—far worse than during the 2008-09 recession.
In recent coverage we have discussed a chain of events that could lead to a break-up of the euro zone (see “After Eurogeddon? Frequently asked questions about the break-up of the euro zone“). We build on that discussion by listing several implications of a collapse of the euro zone, which we define as several countries—mainly in the periphery—leaving the euro zone because of actual or imminent sovereign debt defaults, or because governments no longer believe that they can remain within the currency zone. These events are by no means the only likely consequences of a euro zone collapse. Indeed, there is hardly enough space in this, or any, report to capture the contagion that would strike every country, every company and every asset class. These are, however, among the most significant.
Any figures, such as GDP growth rates, listed in the analysis below are largely qualitative judgments. They are not based on economic modelling, which is especially challenging when so many variables—exchange rates, interest rates, trade flows, capital controls and many others—would be subject to unprecedented change, and when underlying political and economic structures would be in danger of coming apart. We discuss these issues, if only briefly, to convey the severity and the magnitude of the impacts of a potential euro zone break-up.
* Economic output (measured from peak to trough) in the euro zone as a whole could contract by at least 10% and possibly by as much as 25%. This would result from widespread bank collapses as well as major corporate bankruptcies, neither of which occurred after the failure of Lehman Brothers, a US investment bank, in 2008. Legal uncertainty would confound most commercial contracts between countries and companies. Supply chains in much of Europe, and globally, would be seriously disrupted (consider Japan and global car production after the March earthquake); and industrial output in the worst-hit countries would collapse. Tax revenue would plummet as corporate profits evaporated overnight and companies laid off millions of workers; and the public debt burdens that sit at the core of the crisis would surge. Unemployment would climb above 20% in most countries, and to close to 50% in the worst-hit economies. Capital controls would be introduced in weaker countries and possibly in stronger ones to prevent extreme currency appreciation. The European Central Bank (assuming it still existed) would have no choice but to print money to finance public payrolls and keep essential services in the euro zone from collapsing. These effects would ease over time, and output would recover, but it would be years in much of Europe before standards of living returned to pre-crisis levels. The state would have a much larger role in the economy, with banks and many companies in government hands.
* Most of Europe would see a return to the national currencies it used before 1999.The value of these post-euro currencies in the immediate aftermath of a euro break-up would be difficult to predict, given the imposition of capital controls, plunging asset prices, and interest rates that would soar for some countries and fall for others. Assuming currencies could be traded freely, large depreciations/appreciations beyond “fair” values would be likely in the short term. Over a period of several years, the value of post-euro currencies would be determined by factors such as structural external and fiscal imbalances, inflation trends following the break-up and how wage-setting behaviour responded. Taking as a starting point current external imbalances and real effective exchange rates, it is reasonable to assume that a number of countries currently in the euro zone would see large currency depreciations from the current value of the euro. A new Greek currency would be likely to lose two-thirds of its value. Portugal and Spain might experience depreciations of 40-50% and 30-40% respectively, with smaller falls of 20-30% for Ireland and Italy. In the event of a complete break-up of the euro area, most other countries would probably experience modest depreciations of between 0% and 20%. Only Germany, the Netherlands, Finland and Austria would be likely to see their new currencies appreciate—in the case of Germany by between 10% and 20%, but possibly much more.
* Few European banks would survive in their current form. As a break-up loomed, banks in the euro zone’s periphery would suffer runs as customers fearing devaluation under a new currency withdrew euros. Mass insolvencies would result, saddling sovereigns with new liabilities that they could not afford, hastening partial or full defaults on government debt. This would reverberate around the world in waves, as holders of defaulted private and public euro zone debt would themselves be forced to seek state support, with the resulting fall in asset values creating crises for their lenders, wherever they were based and regardless of whether or not they had direct exposure to the euro zone. Some states might choose to seize the local subsidiaries of parent banks based in the worst-affected countries, pre-empting the drainage of funds from the host country and setting the scene for protracted legal battles with the home country during insolvency proceedings. In the former euro zone countries, exchange and capital controls would probably be accompanied by freezes on withdrawals of deposits and savings for a time. Nationalised banking systems would undergo deep restructuring, separating formerly independent banks into a smaller set of firms. These would either be placed into run-off (ie, as entities created to dispose of toxic assets) or operated under state control with an overwhelmingly, if not exclusively, domestic focus.
* The US economy would be plunged into a deep recession if the depression in the euro zone were to be near the low end of our estimate. The sudden tightening of credit conditions, the loss of wealth across the economy and the collapse in external trade would cause the US economy to contract by at least as much as it did during the 2009 slump—3.5%—and possibly by twice that level. The effects on the US initially would come through the financial channel. The direct exposure of US banks to Europe’s periphery is not high, but through derivatives and guarantees their exposure is worth US$640bn, equivalent to 5% of their assets. Lending to French and German banks, which would need to be rescued in the event of a euro collapse, amounts to another US$1.2trn. Perhaps even more importantly, all US financial institutions would suffer large losses on their assets, especially their risky assets, as risk aversion soared. Major US equity indices such as the S&P 500, which more than halved from peak to trough during the 2007-09 crisis, would fall by at least 40% if the euro zone collapsed.
* A euro zone collapse would destroy Barack Obama’s chance of re-election as the US president. A new US recession would push the unemployment rate, now at 8.6%, back above 10%, and possibly much higher. Jobs will be the primary issue in the 2012 election, and no sitting president will stand any chance of re-election with an unemployment rate in double digits. One of the two current front-runners for the Republican party nomination—Newt Gingrich, the former speaker of the House of Representatives, or Mitt Romney, the former governor of the state of Massachusetts—would become the next US president.
* Asian economies would be highly exposed through the trade channel to a depression in Europe, given the high export dependency of the region. India, Indonesia and China stand out in this respect; China’s economy would contract for at least one quarter before the government could respond. There is scope for most countries, led by China, to respond to a collapse in external demand through monetary and fiscal policy, given that interest rates are well above zero and public finances are in good shape in most countries. However, policymakers would not be able to avert recession, possibly quite deep ones. In Asia’s favour, its banks are not heavily reliant on external financing to fund their operations. They would, however, need to rein in their lending in response to an inevitable fall in the value of their assets.