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Three Doomsday Scenarios: What Happens If the Eurozone Breaks Up?
The time has come to confront an ugly truth: The possibility that the Eurozone will break up, or rather fall apart, is growing increasingly likely.
In fact, I'd say given recent developments in Italy the probability of a breakup is as high as 40%.
Indeed, if a country as small as Greece or Portugal were to default or abandon the euro, the effect on the Eurozone would be manageable. The debts of those countries are too small to make more than minor dents in the international financial system, and they represent too small a share of the Eurozone economy for their departure to have much impact.
The psychological effect of their departure would be considerable – if only because Eurozone leaders have expended so much money and effort to bail them out. However, devastated credibility among the major Eurozone leaders is more of a political problem than an economic one.
But now that the markets' focus has moved to Italy and Spain, the Eurozone is really in trouble.
Asking for Trouble
Part of the problem is that in arranging the partial write-down of Greek debt, authorities made it "voluntary," thereby avoiding triggering the $3.8 billion of Greek credit default swaps (CDS) outstanding. Of course, this caused a run on Italian, Spanish, and French debt, as banks that thought they were hedged through CDS have begun selling frantically, since their CDS may not protect them.
Honestly, how stupid can you get! I don't like CDS, but fiddling the system to invalidate them is just asking for trouble. And so far, the only effect has been a considerable increase in the likelihood of a Eurozone breakup.
Italy, Spain, and France are too big to bail out without the European Central Bank (ECB) simply printing euros and buying up those countries' debt. However, if the ECB adopted the latter approach, hyperinflation would almost certainly ensue. Furthermore, the ECB itself would quickly default, since its capital is only $14.6 billion (10.8 billion euros) – a pathetically small amount if it's to start arranging bailouts.
Of course, Europe's taxpayers could then bail out the ECB by lending the money needed to recapitalize the bank, but a moment's thought shows that the natural result of such a policy is ruin.
So what would a breakup of the Eurozone look like? Basically, there are three possibilities.
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