During the past few weeks the centre of economic discussion worldwide has been the Greek default issue, the euro break-up and numerous possible solutions to this problem.
Today, I begin with a series of comments on the eurozone crisis and its possible remedies and consequences. I will start backwards with the worst case scenario – what if the euro falls? What are the possible consequences to the world economy? Inspired by an interesting article from the Financial Times that looked at consequences of a euro break-up on the UK, I use a similar method to paint the global causal effect picture.
A euro break-up won’t only create adverse effects to the eurozone economies; it will yield a significant spillover effect to any countries with strong trade ties with the eurozone. Negative trade linkages will present the direct impact while financial ties and loss of confidence will present an even stronger indirect impact to the world economies.
The first effect is a decrease of exports to any country outside the eurozone which is its significant trading partner. Examples include the UK, US and China in particular. Also, a fall in the value of the euro will result in appreciation of the trade partner currencies, the sterling, the dollar and the renminbi respectively which will come as an additional constraint to exporters.
An even more significant effect will be the financial linkages since all the banks invested in the eurozone will experience significant losses by sovereign defaults and euro banks defaults. A contraction of credit on the domestic market is a natural consequence not only due to huge losses of banks, but also due to a significant decrease of investor and consumer confidence. Loss of confidence will spill over to the real sector and growth will start deteriorating while unemployment may rise even further. The already fragile recovery will be shattered as the final effect may be a deep depression due to a lack of solutions to bring up consumer confidence again. Banks that find themselves in trouble will once again have to be bailed out, only now it is a question where will the money come from. Deficits and debts are on historically high levels and further stimulus will create an inflationary effect, not to mention a significant decrease of investor confidence and country ratings due to ever rising debt levels. The stimulus will not increase demand as investors will be frightened with uncertainty and loss of confidence and thus hold on to their assets. The policymakers will simply run out of options in dealing with the failing system. Nothing they do will create any effects and nothing they do will be enough to start economic recovery. The downward spiral could lead the world into another terrible depression that will again manifest itself through deteriorating trade levels, significant loss of confidence and uncertainty regarding the future, further credit squeeze and decrease of demand.