Perspectives

End of the Eurozone in five fatal scenarios

Published: May 2013

Eurosceptic populism is spreading across Europe. It may even be possible to speak of a trend that revolves around everything that is ‘anti’: anti-globalisation, anti-capitalist and anti-European. National governments are stuck for an answer when it comes to endemic problems, for example massive national debt, growing inequality and political polarisation. A systemic trust crisis undermines the legitimacy of national administrations, parliaments and European institutions – and renders them dysfunctional.

Tensions are mounting between advocates of cutbacks/reforms and champions of fiscal and monetary easing, as well as a lower burden of restructuring. For the moment, these points of view are miles apart but maybe not for much longer: the International Monetary Fund (IMF) itself is changing its tune and a growing number of economists are now coming out in favour of more stimulus. In the meantime, economic problems are on the increase in several core Economic and Monetary Union (EMU) states. The market response is hard to predict.

A positive scenario could unfold as follows:

  • The core and periphery of the EMU agree on a new method for tackling the crisis. Fewer spending cuts will be implemented in the near term and the approach will make more sense (education, research, etc will be spared) as job market reforms continue and more markets are opened. In addition, Germany would accept higher wages.
  • The markets embrace fresh initiatives as the existing policies do not work.
  • The new methods for tackling the crisis bear fruit and growth picks up.

The markets still appear to believe in a happy ending, yet such optimism could prove reckless. It is not possible to ignore the prospect that a negative scenario for the Eurozone will become reality.

Five scenarios

In 2012, Thomas Wright of the think tank Brookings wrote a report entitled ‘What if Europe fails?’ In his view, things can go wrong in four different ways; to this list is added a fifth ‘doom scenario’:

  1. The Eurozone mistakenly thinks it can survive after ‘shedding’ one or more member states.
  2. Under duress, the Eurozone continues to muddle on. Economic growth stays very sluggish and reforms are rarely carried out. Finally, markets have had enough. Soaring bond yields bring matters to a head.
  3. European leaders agree on cutbacks and reforms. Subsequently, these are implemented. The effect is negligible.
  4. At European level, states agree on ways to defuse the crisis but at national level the plans hit a brick wall composed of referendums, parliamentary opposition and rulings by the courts.
  5. Owing to an economic shock, the entire house of cards collapses – for instance, new large-scale and unforeseen problems in the banking system, which spread like viruses.

Trim down or muddle through?

To start with scenario one, it is not likely that the Eurozone will overestimate its resilience and think the exit of its members is no big deal. In recent years, the Eurozone has been beaten black and blue, and confidence is at a low ebb. In addition to various financial/economic factors, major (geo) political interests are at stake. This will prompt the leaders to make desperate attempts to keep the EMU intact.

Scenario two, or ‘muddling on’, may sound negative but has allowed the Eurozone to keep its head above water for quite some time. The Eurozone is very proficient at muddling through. At the same time, this strategy is fragile at best and may be approaching its sell-by date. It worked when Greece, Portugal and Ireland were about to plunge into the abyss, but now the markets have shifted their focus to the big players. If the market gets wind that Europe will wriggle out of imposing structural reforms on Italy, Spain and France, interest rates will rise quickly.

New approach doomed to failure?

Equally, the Eurozone can break apart if political leaders were to agree on new ways to tackle the crisis but these measures do not suffice (scenario three). The core and periphery are slightly more likely to find common ground now that many analysts, the media, economists and (national) politicians argue that cutbacks and reforms should be adapted – in terms of timing, scope and content.

Unfortunately, politicians tend to spend political capital in the wrong order. Ideally, the government would start with structural reforms and then follow these up with (sensible) cutbacks. The latter are less desirable than reforms but better than tax increases, eg the third ‘remedy’ that could help the economies regain their health. Politicians are inclined to start with tax rises, which erode public support for cutbacks. Once they embark on structural reforms, the social base for change has all but crumbled.

Now the Eurozone is in such a bad way that only a combination of the aforementioned instruments could still save the day. Can the Eurozone strike a perfect balance between higher taxes, cutbacks and reforms? Particularly in the light of pervasive populism, growing disillusion among electorates, and steadily decreasing authority of the traditional political and European institutions. An effective cure seems unfeasible in a climate of structurally lower growth, ageing populations and increasing energy dependence. So even if the European political leaders finally manage to work out how to counter the euro crisis, the odds are they will fail.

National obstructionists

That leaves two other scenarios for a doomed Eurozone. Starting with the ‘national level scenario’ (scenario four), even if the European leaders come up with effective measures, they will need to ‘sell’ this package to their voters. Roughly speaking, three types of obstacles could hamper a solution:

  1. National parliaments are blocking progress.
  2. Referendums: ‘the people’ could well reject further European integration.
  3. The judiciary, which could put a stop to European plans: Germany’s Constitutional Court was the focus of attention last year and recently the Constitutional Court of Portugal voted down austerity measures.

Banks and lower authorities: an explosive combination

Finally, there is scenario five: a major economic shock that will shake the Eurozone to its foundations and/or tip it into the abyss. If such a script becomes reality, it will probably start with the financial sector or the lower authorities, which are still knee-deep in complicated derivatives and property that has greatly depreciated in value. As to the financial sector, the problems that started in 2007 have not yet been overcome. The financial sector and authorities are still – perhaps more than ever – intertwined.

Many regional and local governments are in dire straits. Local authorities have invested money hand over fist. Without the benefit of higher knowledge, they bought up complex derivatives and vast pieces of land, on the assumption that prices would go up. Of course, this has turned out to be an illusion.

If skeletons are discovered in the cupboards of regional Italy, at a bank of systemic importance in Spain or in a sizeable German Landesbank, this will have far reaching implications for the Eurozone and market panic could spread quickly.

Success not guaranteed

The above shows there is no guarantee that the Eurozone will find its feet again and defuse the crisis. Many analysts assume that Europe cannot fail, simply because they cannot imagine such a scenario. Political leaders, most of whom understand that a European bloc is imperative in a globalised world, will pull out all the stops to overcome the political hurdles. They do not want to be held responsible for the collapse of the European integration project, which has brought peace and prosperity for 60 years running.

Unfortunately, the history of international relations is riddled with failures. Many of these were deemed unthinkable; the presumption was that the politicians would be too sensible to let things get out of hand. Take the (relatively small-scale) disaster of the US budget sequestration, or the cascade of calamities, unfortunate incidents, mounting tensions and narrow-minded leadership that led to World War I.

History is rife with developments and catastrophes that nobody wanted and that could have been prevented – and yet they still happened. Time has not yet run out for the Eurozone and Europe, but let us not underestimate the likelihood of accidental failure.

For now, markets are fairly sanguine. However, this mood is not compatible with the political-economic developments and prospects for Europe. Extremist parties are gaining in popularity, there has been pressure on the axis Paris-Berlin for quite some time, the UK is obstructing developments that are essential for progress, economic stats continue to disappoint, and nobody seems to have a visionary and inspiring plan for Europe that combines pragmatism, economic common sense and political ingenuity.

If disaster occurs, the reasons will most likely be a combination of the aforementioned scenarios: a major bank that collapses or a central government that needs to bail out an entire region or province. In response, the markets will become jittery as the politicians concoct yet another muddle-on strategy. However, there may well come a time when national parliaments start to revolt (under pressure from dissatisfied voters), or perhaps a Constitutional Court will refuse to play ball. As a result, the Eurozone will grind to a halt and unravel.

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