Crunchtime in the Eurozone
I am handing the mike to my good friend and colleague Edward Hugh who has penned what I consider to be the most accurate analyses to date of the issues facing the European continent.
With fiscal union off the table, there are basically three possibilities. The first is to stay more or less where we are, expanding the ECB's bond-purchasing program and simply trying to hang in there. The stability fund could be increased, but the more numbers start being accounted for in detail, the further away the various parties get from being able to agree. If this continues, the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, because the bank takes the view that the resolution has to come from the politicians.
But with Italy and Spain's combined sovereign refinancing needs between now and the end of 2012 totaling about 660 billion euros, and given the financing needs of the banks on top of this figure, reaching agreement to expand the bailout mechanism looks pretty improbable, especially when one considers that there's no turning back once it starts. So, at some point, the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed toward the brink of breakdown.
The second possibility would be to disband the union entirely, leaving each member to go back to its national currency. This would be a disastrous outcome for all concerned and for the global financial system. Coordinating the unwinding of cross-country counterliabilities would be a nightmare given the level of interlocking corporate and sovereign bond markets. The sudden disappearance of one of the major global currencies of reference would also cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is happening to gold, the Swiss franc, and the Japanese yen to catch a glimpse of what would be in store. Of course, this kind of violent unwinding would never be undertaken voluntarily, but that doesn't mean that it is impossible -- particularly if solutions are not found and the force of market pressure continues.
Fortunately there is a third alternative: The eurozone could be split in two, creating two separate (and unequal) euro currencies. Naturally, the composition of the groups would be a matter of negotiation because some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, the Netherlands, and Austria. It might even take Estonia, which has been making it pretty clear that it would also be up for the ride. Spain, Italy, and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.