Eurozone Meltdown

The full briefing is available for download. See the download link at the end of the introduction.

Introduction

We have long dismissed the probability of a breakup of the euro area as idle talk among the chattering classes and speculators. Anyone who would have placed a bet on this proposition would have lost heavily during the first ten years of the euro’s existence. The financial crisis and the way European governments responded to it have changed the odds in our view. We still believe a breakup of the euro area to be unlikely, but the probability is no longer trivial. This is still true after the stock market rally in March 2009 and the ensuing temporary fall in risk aversion among investors. The danger is not over. The aim of this briefing note is to assess this probability in some detail.

In doing so, we want to alert investors and policy makers to some of the risks involved, but also to debunk some of the common misconceptions about the legal, economic and political aspects of a hypothetical euro crisis. The most frequently mentioned breakup scenario by financial market participants, in which a country in or near default would voluntarily leave the euro area, is in our view so unlikely that we would rate the probability as close to zero. But there are some disturbing scenarios that we cannot dismiss so easily.

When we talk about breakup of the euro area in this briefing note, we mean one of two possibilities: one or more countries leave the euro area, while the euro area itself continues with a smaller membership base, or the possibility that the euro area itself would cease to exist. It will be clear in the context of each of our eight sceanrios, which of the two principal breakup possibilities we refer to.

The breakup scenarios are not meant to represent a complete set of all conceivable states, but a subset we consider relevant for investors and policy makers. The scenarios include speculative attacks, either on member states directly, via the market for credit default swaps for example, or on non-euro area countries with spillover effects to the euro area. We have also included a couple of long-term scenarios, which do not necessarily involve speculative attacks. Not all eight scenarios are plausible in our view. But some are.

We are absolutely not trying to incite investors to take a bet against the euro area. We ourselves would not. As the bear market rally in March 2009 has shown, such investment strategies are fraught with danger. Equally, the possibility that the European Central Bank might adopt a policy of quantitative easing could produce sudden downward pressure on sovereign bond yields. Also remember: When George Soros famously attacked the exchange-rate mechanism, the financial sector was in good health. That is not the case now, and it is not clear to us whether the financial sector is strong enough to launch a speculative attack, nor confident enough given that so many banks are now directly or indirectly dependent on governments.

The euro area may be a fair-weather construction, but it may be more peristent than some of its critics maintain. But it is not invulnerable. This is what our briefing note will try to show.