09 August 2012

Douglas J Elliott: The euro crisis faces three possible scenarios

The Happy Scenario: A Gradual Workout of the Problems (10 per cent probability)

There is a chance the major steps Europe has taken, usually reluctantly, will actually be enough to slowly get the continent past the immediate crises and give it the time to deal with the longer-run issues. European nations have agreed to major constraints on their deficits and have taken many actions to improve their economies. Perhaps these, and follow-on actions, will be enough.

The Most Likely Scenario: Things Get Worse Before They Get Better (65 per cent probability)

I do not believe European leaders have yet done what they really need to do to restore market confidence. They have committed to major steps but expressed so many reservations and conditions about them that one cannot have complete confidence even if these steps were enough. I expect a blow-up somewhere in Europe -- and there are many candidates for it -- that will shake investor confidence in the euro area sufficiently to cause the closure of private funding markets for Spain or Italy, which would quickly spread to the other nations. This would be an intolerable situation, given the large size of these two countries, which could lead to a series of national defaults if the euro area failed to pull together quickly.

My belief in this scenario is that the key leaders would finally have a summit at which they all committed to the full extent to the actions needed to restore market confidence, in order to prevent total disaster. This would require the strong countries such as Germany to agree to back the debt of the weaker countries, through any one of a whole set of potential mechanisms, ranging from an outright debt guarantee to massive bond purchases by the European Stability Mechanism or the European Central Bank.

In return, the weaker countries would have to accept a strong degree of control of their budgets by European authorities, requiring many painful but necessary changes to the ways their economies operate. The International Monetary Fund would also be brought in, partly for its money but mostly as a relatively neutral arbiter to ensure the needed actions are taken. Finally, the banking systems in Europe would become subject to more-integrated European supervision and a pan-European deposit guarantee fund and mechanisms for dealing with failing banks.

The Disaster Scenario: It All Falls Apart (25 per cent probability)

In this case, there is the same blow-up as projected in the likely scenario, but the leaders are unable to reach agreement at the key summit or the deal falls apart due to political pressures afterwards. The result is a series of national defaults in Greece (for the second time), Portugal, Spain, Italy, Ireland and possibly other countries, such as Belgium. Greece might be forced by circumstances to withdraw from the euro and it is possible that a few other countries would as well. Europe would fall into a deep recession, the US into a mild recession, and the growth of countries such as China would slow markedly. 

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