Euro break-up – effects beyond the eurozone

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.

Comments

  1. Unknown18 October 2012 at 20:29

    Great summary...
    Knowing what happened when fourth-largest US investment bank collapsed, I can not think what would happen if currency of world's largest economy collapses.
    Although your summary terrifies me on the first site, it encourages me on the other hand.
    Knowing the consequences German voters should not have any doubts about supporting common currency (with respecting of fiscal requirements of course). After all, their economy profited from it the most (I'm not trying to mitigate their own credits for it), but there is no way that they could make such export increase without it (Deutche Mark would appreciate drastically otherwise). They can also lose as much as other economies (maybe even more), knowing that export contributes 40% to their GDP, and considering German banks exposures to other EU countries (both government and companies).
    It is important that people like you continue to educate non-economists (majority of population) i.e. voters so that they can finally support politicians/bureaucrats in taking decisive action to end this catastrophe...

    ReplyDelete
    Replies
    1. Vuk Vukovic18 October 2012 at 23:05

      Thank you very much for your confidence, however, there are more popular and smarter bloggers out there that still don't seem to reach the regular population in way that it can make a significant change. There was some effect from bloggers on the Fed's recent stimulus (I covered that here), but apart from that it's really rare that the policymakers will listen. But it is a new platform for opinions and it is getting more and more coverage and influence (not my blog, but blogs in general), so perhaps one day it will become a place to educate the 'non-economists', and help increase voter information on issues like this one.

      As for your opinion on Germany, I agree with you completely! That's why I also believe that a euro break-up is unlikely to happen. Perhaps a divide between a core and a periphery, but that also is a last resort solution, in my opinion. Even back in November 2011 when notable newspapers like the FT or the Economist were predicting that the euro won't survive Christmas, I refused to believe in that scenario.

      Delete

Post a Comment

Popular posts from this blog

Short-selling explained (case study: movie "Trading Places")

Image
After seeing the movie "Trading Places" (1983), starring Eddie Murphy and Dan Aykroyd, for the thousandth time during the holiday season, I decided to write a quick post explaining what happened at the end of this movie that gets so many people puzzled (including me for the first couple of times I've seen it). This entertaining 80s comedy can actually teach you more about finance and trading than any other Hollywood movie (not counting documentaries), including the infamous "Wall Street" (1987), starring Michael Douglas as the ruthless Gordon Gecko, and especially the latest Scorsese film "The Wolf of Wall Street" (2013). Anyway, we all know the story from Trading Places. Dan Aykroyd plays a snobbish investor Louis Winthorpe ("the Third"), while Eddie Murphy plays a street con artist Billy Ray Valentine whose lives get reversed as a result of a bet between two cruel millionaires, the Duke brothers. The Dukes own a commodities bro
Read more

Economic history: mercantilism and international trade

Image
All too often during poor economic times many debunked economic fallacies of the past get reinvented. The reason is simple: a search for ideas and solutions alternative to the "mainstream" (however we define it) allows those who succumb to these fallacies to repeat the ancient errors classical economics was hoping to get rid of. The short-termism of politics plays a crucial role in the process of persistent perpetuation of such fallacies. This is why in times like these it is essential to go back in economic history and debunk some of the ideas that tend to surface repeatedly. In the following couple of posts, I attempt to do just that.  Misunderstanding trade  One of the most misunderstood areas of economics is international trade. More precisely, the idea that if we were to boost net exports - by subsidizing exports and constraining imports - we can achieve higher GDP growth. If one looks at the simple arithmetic of a standard Keynesian macro model: Y=C+I+G+NX, the
Read more

Rent-seeking explained: Removing barriers to entry in the taxi market

Image
The taxi market is undoubtedly one of the best examples of something economists like to call rent-seeking . What does this phenomenon stand for and why do economists (particularly political economists) devote a lot of attention to it?  The classical definition was given by Gordon Tullock back in his  1967  seminal paper "The welfare cost of tariffs, monopolies and theft" , even though the phrase itself was coined by Anne Krueger in 1974 .  Rent-seeking is a process of gaining private benefits through the political process (by lobbying or logrolling for example). It implies gaining protection for a certain privileged group, which in return promises political support, large campaign contributions, or even bribes. This protection varies from giving a monopoly status to a certain company, regulating market entry than hampers competition (such as introducing licences to specific occupations), imposing tariffs to import goods to protect the domestic industry, handing out su
Read more

Graphs (images) of the week: Separated by a border

Image
Usually comparing countries or regions requires looking at GDP growth data, GDP per capita, living standards, relative income or even the happiness index. But even a simple areal glimpse at the borders separating two systems can be more than enough to conclude which country is richer, healthier, more educated and on average more prosperous. It tells us that the causes of between-country differences have to be more than just climate, geography, culture or mentality. Particularly when the same nation is separated by nothing more than a border depicting the striking differences in political systems of the two countries (a classical example here are East and West Germany, but an equally good example can be North or South Korea).  As a result I found that the following set of images paint a better  picture  on between-country differences   than any existing data on global inequality.  The first one is from a  blog post I encountered on the Why Nations Fail blog, comparing the citi
Read more