EMU Break-up: Quantifying the Unthinkable

- "Suddenly the unthinkable is thinkable. The possibility that one or more of the members of European Monetary Union (EMU) might leave is no longer being dismissed, even by Eurozone politicians. In this report, we discuss not the probability of this – readers will doubtless have their own views – but rather its potential economic and financial market impact. Complete break-up would have effects that dwarf the post Lehman Brothers collapse."
- "EMU was designed to be irreversible. The sovereign debt crisis has set the markets thinking that this may no longer be so. German politicians are talking openly of EMU exit being an option. But given the political dimension of decisions to leave EMU, there is no definitive way of assessing their probability, although this does not stop commentators debating it endlessly."
- "Our purpose in this report is rather different; we assess not the probability of EMU break-up, but its impact. Calibrating the impact is especially challenging, given the unprecedentedscale and ambition of EMU. Indeed, it might be said that this is trying to “quantify the unquantifiable”. Nevertheless, faced with this risk, investors need to take a view."
- "We evaluate two boundary cases: a Greek exit and a complete break-up. Although there are many permutations in between, our results should give some indication of their potential impact as well."
- "While the initial economic damage of a Greek exit is naturally focused on Greece itself, the effects elsewhere are non-trivial. While Greek output falls by 7½% relative to our base case, the remaining Eurozone economies could see their output fall by as much as 1%. Losses on Greek assets spread the pain across Europe and beyond."
- "By comparison, the impact of complete break-up is dramatic and traumatic. In the first year, output falls by between 5%and 9% across the various former member states, and asset prices plummet. With their new currencies falling by 50% or more, the peripheral economies such as Spain and Portugal see their inflation rates soar towards double-digits. Meanwhile, Germany and other core countries suffer a deflationary shock. Indeed, with the US dollar surging on safe haven flows to the equivalent of 0.85 EUR/USD, the US also suffers a bout of deflation."
- "As a result, the break-up scenario leads to massive divergence in both interest rates and bond yields. Ten year bond yields in Germany fall below 1% while those in the peripheral markets might soar into a 7-12% range."
- "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. However, the initial trauma outlined in this report is sufficiently grave to give pause for thought to those who blithely propose EMU exit as policy option."
INGBank Global Economics 20100707

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