Monday, 17 October 2011

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.

2 comments:

  1. 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...

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    Replies
    1. 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.

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