The End of the Euro. Again.

Written by  //  September 21, 2011  //  Economic & Social Policy  //  2 Comments

Doomsday scenarios abound

Another week and yet another unprecedented act of coordination by the European Central Bank saves the day! Last week, five of the world’s largest central banks stood together to pledge to provide dollar-financing of an unlimited amount to any bank with liquidity problems. This facility is provided in addition to existing ECB instruments, which allow for unlimited euro financing of struggling banks. The world steps back once more from the brink of financial disaster! At least until the next week.

It is truly exasperating to read about the European sovereign debt crisis because nothing in the news ever seems to change. Since the first emergency bail-out fund set up for Greece in May 2010, European countries have veered perilously close to sovereign default and European financial institutions have run out of liquidity on several occasions. Each time, the ECB and the wider Eurozone have come together in the eleventh hour to mount a short-term rescue of the struggling country or bank. This fire-fighting has been followed by much hand-wringing, finger-pointing, and fiery speech-making, particularly by the Germans, about how financial profligacy should not be tolerated, let alone enabled. Then comes the next crisis and the firemen rush to the rescue again.

Greece, Ireland, Portugal, Spain and now Italy: through each crisis loop, one gets the distinct impression of being stuck at the same level of a bad video game. Even so, one does get the point of the escalating fear – the fall-out of the default of any one European government could well eclipse the 2008 liquidity crisis.

Worst-case scenario

If Greece refuses to pay its debt, it would suffer, in the first place, all of the incumbent miseries of a default on sovereign debt. The country would be unable to raise any new funding, it would be forced to drastically reduce expenditure and fail to pay salaries to many employees. The economy would shrink, leading to a political crisis and a heightened state of civil unrest. The banking system would face huge losses since domestic banks are major holders of government debt and the lack of credit would wreck the economy further. A government desperate for cash may then be forced to exit the Eurozone and return to the drachma, which it can then print to pay its bills.

This sounds pretty bad but for the Greeks, but hardly Apocalyptic for the rest of the world. What makes the Greece default our problem is the prospect of crisis in the European banking system. Holders of Greek debt include institutions such as German insurance companies, French pension funds as well as the European Central Bank itself. Fear and uncertainty about the exposure of private financial institutions to worthless debt would lead to panic in European markets, extreme volatility and a funding crisis at those financial institutions, which are even remotely suspected to be in some sort of trouble. This very process repeats itself at the sovereign level. Even as Greece defaults on its debt, the attention shifts to those economies that could be next in line. Euros fly to safe havens putting more domestic financial institutions under extreme pressure and generating further solvency crises. The likely end is the break up of the euro.

The only possible circuit-breaker is concerted and coordinated effort by the rest of the Eurozone – including Germany – as well as by the ECB to change the current trajectory towards fiscal disaster. So far, this coordination has only come together to avert crises in the nick of time without being seen to have an impact that is sustainable beyond the next two years. Till this level of coordination takes place, Europe will continue to teeter from the brink of one collapse to another.

7.5 per cent growth might be very optimistic

Why do we in India care? The last crisis certainly dented growth and required fiscal stimulus programmes that grew a fiscal deficit that was, at the time, fairly modest. There is less scope for increasing that deficit now. Growth is already faltering on account of higher interest rates to check inflation as well as the economic slowdown in the United States and Europe. A fresh crisis would probably change the path of Indian economic growth to a decidedly lower one over the next three years. Foreign investment and exports will suffer, the rupee will decline dramatically and the government’s hands will be largely tied on account of the high levels of inflation.

In India, there is a lot of concern over the fact that growth forecasts are being revised downward to 7.5 per cent. A crisis in Europe would make any growth above 7 per cent look astoundingly good.

2 Comments on "The End of the Euro. Again."

  1. Alok September 21, 2011 at 5:25 pm ·

    Welcome back to C20s Anisha! 🙂

    As always, a pleasure reading your posts.

  2. Anisha September 24, 2011 at 8:08 am ·

    Thanks, Alok! Hope to be more regular these days 🙂

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