EMU break-up risks global deflation shock that would dwarf Lehman collapse, warns ING
by Ambrose Evans-Pritchard
Originally published 7 July, 2010
A full-fledged disintegration of the eurozone would trigger the worst economic crisis in modern history, devastate every country in Europe including Germany, and inflict a deflationary shock on the US. There would be no winners, warns the Dutch bank ING in a new report “Quantifying the Unthinkable”
The end of the Deutschemark was marked in the northern German state Lower Saxony by a funeral.
“COMPLETE BREAK-UP WOULD HAVE EFFECTS THAT DWARF the post Lehman Brothers collapse. Governments would find themselves having to bail out banks again, worsening already fragile government finances. The risk of at least a temporary break-down in payments systems would be enormous, ” said the report by Mark Cliffe, Maarten Leen, and Peter Vanden Houte.
“Initial trauma is sufficiently grave to give pause for thought to those who blithely propose EMU exit as a policy option,” it said, a rebuke to those German politicians and economists who have talked openly of shaking out weaker members.
The new Greek drachma would crash by 80pc against the new Deutschemark. The currencies of Spain, Portugal, and Ireland would fall by 50pc or more, causing inflation to soar into double-digits. “The impact is dramatic and traumatic,” it said. ING has attempted to unpick the complex consequences of break-up scenarios, concluding that even a surgical exit by Greece alone would hurt everybody, and be suicidal for Greece. Both weak and strong states would suffer violent downturns if EMU unravelled altogether, though each in very different ways. “In the first year, output falls by between 5pc and 9pc across the various former member states,” it said.
The German sphere would face a “deflationary shock”. 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. East Europe would contract 5pc in 2011 alone. Safe-haven flows to core debt markets would drive down yields on 10-year US, German, and Dutch bonds to near 0.5pc, by far the lowest ever. Club Med yields would decouple brutally, rising to between 7pc and 12pc, “capital controls, notwithstanding.”
This is the picture of a world falling apart. It is an outcome that Angela Merkel, the German Chancellor, now seems determined to avoid, after dragging her feet over the Spring. The Bundestag has backed Germany’s share of the €110bn rescue for Greece, and the €750bn EU-IMF bail-out for future casualties should they need it. The Bundesbank has lifted its de facto veto on purchases of Club Med bonds by the European Central Bank.
Yet markets have failed to stabilise. Spreads on 10-year Greek bonds are still 750 basis points over Bunds. Investors clearly doubt whether the Greek austerity policy of wage deflation can ever work, or whether EU states will back their words with money, or both. The spreads are 285 for Portgual, 272 for Ireland, and 213 for Spain.
The markets perhaps sense that the bail-out battles in Germany are not yet over. There are four complaints lodged at the German constitutional court arguing that the rescues breach EU treaty law and therefore German basic law. While the court has refused an immediate injunction to block aid, it has not yet ruled on the cases. A group of five professors has just expanded its original complaint against the Greek rescue to cover the EU’s €440bn Stability Facility, describing the methods used to ram through the measures as “putschist” and anti-democratic. “This course is leading Germany to ruin,” they said.
Germany’s Centre for European Politics in Freiburg has joined the fray with a report arguing that the use of €60bn of EU money under Article 122 of the Lisbon Treaty to support the rescue package is illegal. “It is a complete violation of our constitutional law and the judges at the court will have to say so if a case reaches them, even though they are afraid of the economic consequences,” said the author, Dr Thiemo Jeck. Bavarian politician Peter Gauweiler aims to file a fresh case along these lines.
ING’s global strategist Mark Cliffe said any Anglo-Saxon Schadenfreude at a euro break-up would be short-lived. The UK economy would shrink by 4.5pc from 2011-2012. “It would be a very unpleasant experience,” he said.
Safe-haven flows pouring into Britain would drive sterling through the roof. Eurozone demand for UK exports would contract viciously. Pension funds would suffer fat losses on eurozone assets. UK lenders would face havoc again though a web of cross-border linkages. The Dutch bank does not make any judgement on the merits of EMU, or on whether it is an ‘optimal currency area’, nor does it explore half-way options such as a split into a hard Teutonic euro and a weak Latin euro.
The report said break-up talk is “no longer just a figment of fevered Anglo-Saxon imaginations”. It has spread into top policy-making circles in the eurozone and must now be analysed as a serious tail-risk. A survey of 440 heads of global banks and companies by RBC Capital Markets found that 50pc expect at least one country to leave EMU by 2013, and a quarter expect a complete collapse.
ING said heavily indebted states such as Greece would not gain relief by escaping EMU and devaluing since their debt burden would remain, even if government bonds are switched into the new currency. This is a controversial point. If Greece devalues and defaults as well, the calculus is different. Many big bust-ups entail both, such as the Argentine crisis in 2001. Some Argentines argue that their trauma proved cathartic, pulling the country out of a destructive downward spiral. If Greek, Portuguese or Spanish leaders ever start to ask their own Argentine questions as austerity grinds on, and unemployment grinds higher, events will run their ineluctable political course regardless of the greater risks.