Europe's World: Three scenarios for the unfolding eurozone crisis (Graham Bishop article)

01 June 2011

To try to predict the twists and turns of the eurozone debt crisis is very risky. Graham Bishop outlines three possible scenarios, ranging from defaults that might cripple the EU itself, to a federal eurozone that could become a model of financial probity.

In these uncertain times, have European politicians any hope of regaining control of the eurozone crisis? Probably yes, if they are bold and visionary. Forecasting events is very risky, but scenario analysis can be a useful technique for mapping possible outcomes.

 

The European Commission has proposed six measures to enable the eurozone states to encourage – and at worst force – “risky” states to improve their competitiveness. But the European Central Bank (ECB) has criticised these proposals as flawed because there is insufficient “automaticity” in the enforcement and sanctioning process. Nonetheless, when the European Council met in late March it endorsed the eurozone’s “Pact for the Euro” which, it was boldly stated, marks a “new quality of economic policy co-ordination in the euro area”.

The period up to the end of June will see these statements tested, by the willingness of euro area governments to agree to the operational details of this co-ordination, and to abide by the results. The political backlash in Greece, Ireland and Portugal against the measures designed to improve their competitiveness already raises questions about the political will to stay the course. Critically, the new treaty changes that will create the European Stability Mechanism (ESM) must be agreed by all states.

So the question now is whether investors will be able to add back their own assumptions of losses and test the capital strength of the banking system. Will this reveal the fatal flaw in the process? Eurozone governments have committed to preparing contingency plans for the results of the formal tests, but will they be ready and able to deal with the market’s assessment of the real situation about the solvency of banks where the market has now priced in the strong probability of defaults that will impinge on “banking book” debt holdings, and thus the solvency of the banks that hold the debt? There is also the problem of banks that face a failure of a major counter-party in the interbank or derivatives market. All this suggests three scenarios for the future of the eurozone during the next two or three years. Looking at these may be the best mechanism to illustrate the choices that must be made.

Scenario 1: Inflationary debt spiral;
Scenario 2: Default;
Scenario 3: A strong, federal ‘eurozone’ emerges.

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