Europes scary debt disaster has deteriorated to the point that there is now mainstream speculation about what would happen if the euro zone threw in the towel and collapsed.
The notion, nearly unthinkable just months ago, is fueled by surging bond yields in Greece and Italy, disgust in Germany and France over bailing out their weaker neighbors and growing concerns about the health of the European financial system.
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Despite worsening conditions, a collapse of the euro zone remains highly improbable because of the enormous economic and political costs it would likely inflict on weak and strong nations alike.
Its not going to happen, said Adolfo Laurenti, senior economist at Mesirow Financial. You do not expect California or Illinois to secede from the United States because their spending has gone out of control. In Europe, its not in anybodys interest for that to happen.
That doesnt mean the calls for the expulsion of the weaker euro-zone countries or the exit of the stronger nations wont grow louder. While they often downplay the negative consequences of the euro zone collapsing, these arguments do underscore the short-term crisis and long-term structural problems paralyzing the union.
Europes Addiction to Debt
Right now Europe is suffering from a full-blown debt crisis that has been caused by drunken spending in a number of slow-growing countries.
The list of problem countries is headlined by Greece, where the debt-to-GDP level has soared to 142.8% and its unemployment rate stood at 16% in June, up from 11.6% a year earlier. The situation isnt much better in Italy and Portugal, where public debt represents 119% and 93% of GDP, respectively
Greece has been unable to tap the capital markets to raise money and the yield on its one-year bond surged this week to an incredible 95%, while the cost to insure its debt his soared to record highs.
Those countries havent been able to grow fast enough to repay their debts, putting pressure on Europes stronger countries like Germany, France and the Netherlands -- whose banks own much of that near-toxic debt -- to provide emergency loans.
The crisis has dragged down the euro, weighed on the economies of rich and poor countries alike and caused great distress in financial markets around the world. Germanys DAX retreated 6.5% so far in September and has already lost one-fifth of its value year-to-date.
Right now the entire euro is bound to the weakest members, not the strongest. Thats not tolerable, said Jack Goldstone, a senior fellow at George Mason University. I just dont see how this is going to hold together.
At the same time, the euro zone is being handcuffed by structural problems that exist in a monetary marriage of 17 varying economies with conflicting spending habits.
The root of the problem, said Josh Feinman, global chief economist at DB Advisors, is you have this monetary union of linking countries with very different fiscal positions and no overarching mechanism for correcting that.
These complex issues represent the most serious threat to the euro since it was formed in 1999 and have raised the specter of policy makers deciding to abandon their monetary union experiment altogether.
Its something that would have been hard to contemplate a year or two ago and is now on the radar screen, said Feinman.
Weaker countries are likely tempted to ditch the euro because this would enable them to devalue their own currencies in an effort to boost exports and pay back debt.
No one knows for sure exactly what a break-up of the euro zone would look like, but few think it would be pretty.
In a research note released this week, UBS warned that a weak country leaving the euro would suffer from sovereign default, corporate defaults, collapse of international trade and the implosion of its banking system.
UBS estimates ditching the euro would cost a weaker country 9,500 to 11,500 euros per person in the first year representing 40% to 50% of gross domestic product. It also estimates a cost of 3,000 to 4,000 euros per person per year over subsequent years.
It would spread fear and panic throughout the financial markets. Itd be a mess economically and politically as well, said Feinman.
As if the economic costs arent enough reason to rule this out, its worth pointing out there currently is no legal mechanism for a country to be expelled from the euro zone.
Costly Exit for Germany
Another scenario calls for a strong country to depart the euro zone and stand on their own currency.
For Germany, whose exports rely on the parity provided by the euro, this would result in a costly return to the much stronger Deutsche mark. Thats why UBS predicted a collapse of international trade for Germany, in addition to corporate defaults and a pricey recapitalization of the countrys banking system.
UBS estimates this disaster would cost 6,000 to 8,000 euros for every German adult and child in the first year, representing20% to 25% of Germanys GDP, which hit $2.94 trillion last year. It would also cost 3,500 to 4,500 euros per person per year thereafter.
At the same time, Germany jumping ship would leave the rest of Europe, and perhaps maybe much of the developed world, in shambles.
That would be the scenario that leads to the second Great Recession and maybe worse, said Gary Hufbauer, an international economist at the Peterson Institute for International Economics.
For Europe, a loss of key members would also curb its diplomatic influence and could even lead to serious arguments between nations.
Hufbauer said the remaining members of the euro zone would see the move as a slap in the face, setting the stage for anti-German actions like boycotts and high tariffs.
For all of these reasons, UBS puts the chances of a euro-zone breakup at close to zero.
Others warn not to discount the chances of a policy error.
I think the fears [of a break-up] are justified mainly because the politicians are stupid, said Goldstone. I dont think you can say the economic leadership is doing whats eminently economically sensible. Theyre doing what is politically feasible.
Structural, Membership Shuffle Ahead?
Still, if you believe it would hurt too much for rich countries to abandon the union and poor countries cannot be expelled from it, that appears to leave just two options.
Under the current structure and with the current membership, the euro does not work, UBS economist Stephane Deo wrote. Either the current structure will have to change or the current membership will have to change.
Under the latter scenario, the euro zone offers Greece and possibly another country or two a golden parachute in exchange for agreeing to exit the monetary union.
The incentive package would be aimed at mitigating the economic consequences highlighted above and securing Greeces approval to secede.
While this move could take some of the pressure off of the euro zone, some believe it would create a domino effect that would just shift the focus to other countries carrying heavy debt loads, such as Spain and Italy.
In the other scenario, the crisis worsens to the point that public opinion in rich countries shifts in favor of bailing out their troubled neighbors, but only in exchange for very painful and very controversial fiscal unity.
Its not clear precisely what this unity would consist of, but the general goal would be to more closely link these 17 nations on the spending and tax side and create mechanisms to enforce new debt rules.
This could include the creation of euro-zone bonds as well as citizens giving up some of their economic say in exchange for a greater voice on who leads the union.
That has its downsides too, politically and economically, said Feinman. There are a lot of people in Europe who dont have a stomach for that either.
Still, UBS estimates the cost for Germany of bailing out Greece, Ireland and Portugal entirely after they default would be much less than leaving the euro: roughly 1,000 euros per German citizen in a single hit.
We believe that some kind of fiscal union is going to be required to save the euro, wrote Deo.