GEMO Q1 2012: No euro way out

In our view, there is a way out – if policy makers across Europe, and most notably those in Frankfurt, come to their senses and do what needs doing. There is no ‘partial solution’; instead, a wholesale recapitalisation of the European banking system is required. Based on previous experience, we estimate the scale of the necessary ECB intervention is of the order of 20% of Euro Area GDP, or around EUR 1.8 trillion. Now that push has come to shove, we judge that this is the path they will take.

Central Bank intervention works, and in the US it is starting to bear fruit. Indeed, a key theme in our forecast is that the US has made clear progress in addressing its structural problems, and is now showing signs of a modest upturn. But unless there is a speedy resolution of the euro crisis, the nascent US recovery will be overwhelmed by contagion through the banking sector.

Logic does not always prevail. So there are major risks to our guardedly optimistic view.
But these alternatives are truly horrendous:

• Making the profligate pay, or the "cutting off one's nose to spite one's face" approach. Austerity, when carried out within a fixed exchange rate regime, with no monetary accommodation, will only make things worse. Indeed, it is not an exaggeration to say that it could lead to an outcome much like the Great Depression, with the single currency playing the role of the ‘barbarous relic’ forcing all economies still on it to deflate. It is fear of just such an outcome that caused S&P to downgrade nine euro area countries at the end of last week.

• Lehman's all over again. Failing to heed the lessons of 2008, there is a risk that Euro Area politicians allow one or more countries to default, and leave the euro. Letting Greece go or – worse still – forcing it out will not solve anything. We call this the Lehman’s strategy. It would not end with Greece. It would simply set in train a domino effect. Following a default by Greece, the chance of a sovereign default elsewhere in Europe remains greater than 50% until the capitulation of Spain finally tips Italy over the edge. Once Italy has gone, following Greece, Portugal, Ireland and Spain, the next most likely defaulter is France, with a 43% conditional probability.

The crisis is a systemic problem, and is not confined to one or even a handful of errant countries. Muddling through is no longer an option.

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