Thursday, July 08, 2010

How much would a eurozone break-up cost?

A first attempt (to our knowledge at least) at quantifying the cost of a possible break-up of the eurozone has been made by Dutch bank ING. The report carries the title “Quantifying the Unthinkable”. A break-up of the eurozone, it says, “would have effects that dwarf the post Lehman Brothers collapse”.

The report predicts that a new Greek drachma would crash by 80pc against the new Deutschmark, and the currencies of Spain, Portugal, and Ireland would fall by 50pc or more, causing inflation to soar into double-digits. The Italian currency would devalue with 25%, the French with 15% and the currencies of the Benelux, Austria, Finland with 7.5%.

It goes on to suggest that "in the Eurozone output falls [would] range from -4% in Germany to -9% in Greece. Elsewhere the impact is particularly large in neighbouring European economies. Thus GDP falls 3% in the UK and 5% in Central and Eastern Europe."

It notes that the Germany and the stronger economies would face a "deflationary shock", while "weaker leavers could see inflation hit double digits as their currencies plunge". The US dollar would rocket to 85 cents against the euro equivalent, with a “temporary overshoot” to near 75 cents. This would tip the US into acute deflation, threatening North America with a double-dip recession.

However, the analysis also admits – and this is key – that it doesn’t take into account the costs of keeping the eurozone intact, noting “Some argue that the current sovereign debt crisis has exposed EMU as not being what economists would call an optimal currency area. We do not address the potential long-term pros and cons of dismantling EMU here.” To pretend that the one-off cost of a break-up wouldn’t be huge is silly. But any such estimates must be weighed against the medium to long-term drawbacks (i.e. wealth transfers and permanent losses of competiveness) of keeping the eurozone intact. The note leaves that question open. The estimates themselves also strike us as suspiciously (and spuriously) accurate. But preliminary work on this should still be welcome. We now anxiously await the first study on the second part of the question.

A comment on Seeking Alpha raises the potential issue: "Are we being blackmailed? (...) Why would large European banks and insurers intentionally write up exaggerated risks in the event of a eurozone breakup? (...) ING and most other European financial organisations own trillions of public and private sector eurodebt. They know that if a Greece bailed out of the euro, it would also default on its debt (or devalue it in euros) and ING and others would take a mighty haircut. And considering there would appear to be no upside to a eurozone breakup (from the perspective of an ING), it seems natural they would want to exaggerate the risks to the wider European economy."

Unnecessarily conspiratorial, but there’s no doubt that certain banks have huge stakes in this.

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