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Eurozone Crisis: Where Will the Economy Go?

This post is part of our special coverage Europe in Crisis.

Economists would be hard pressed to forecast the future of Europe's bailouts and the consequences of the current financial crisis. While opinions differ, reactions abound online to try to make sense of what future awaits for the Eurozone.

Where is the economy going? That question was put to Maria Karchilaki, a Greek  journalist and the Foreign Desk Anchor/Correspondent for MEGA TV. She replied:

@karhilam: @efleischer I don't know, really. I'm not optimistic, though. This is an economic Katrina and we are still in the middle of it.

Euro coin. Image by Civitas (CC BY-NC-SA 2.0)

None of the region’s biggest banks pass a stress test. BNP Palibras has slashed its exposure to Italy and Greece, as has RBS, even though it is apparently awash with liquidity. Dexia, Commerzbank, Credit Agricole, and HSBC are seeking to cut their exposure.

France is planning to cut 20% of its budget deficit, Ireland is planning 12.4 billion in budget cuts and ECB (European Central Bank) interest rates are being kept at 1.25%.

On the micro level, people are not in a charitable mood, one retired truck driver in Greece went so far as to tell The New York Times:

[I am] impressed that the people have not yet stormed into Parliament and burned the politicians alive — like a souvlaki [type of kebab].

The question, “Where will the economy go over the next two months?” was put to the following reporters and Twitter users before the resignation of former Greek Prime Minister Papandreou and former Italian Prime Minister Berlusconi.

Efthimia Efthimiou, a Greek journalist, writes:

@EfiEfthimiou: @efleischer … difficult to say right now. Things r changing from hour to hour …

Yannis Koutsomitis, another journalist, replied:

@YanniKouts @efleischer There is a strong possibility that political logic will prevail in Italy and Greece in the next few days. That could calm markets for a while. If political turmoil in these countries continues there's a real chance the euro zone crisis will climax with unpredictable outcomes.

Right now the outcomes are pointing in this direction: John Reed of The Financial Times writes that Italian tyre producer Pirelli has “drafted a contingency plan that factors in a 10 per cent drop in car sales and 20 per cent fall in truck sales globally. That would be a drop as big as that seen after Lehman Brothers’ collapse.” (Though that's emphasized as a worst-case scenario.)

Meanwhile, a WikiLeaks cable written in 2010 began to get to work on (if it's necessary) how one might go about declaring a ‘Eurozone Chapter 11‘.

Douglas Fraser at the BBC discusses what would happen if multiple defaults were in the cards:

If Greece, Portugal and Ireland hit that level of default, half of German banks’ capital buffers are gone, a third of Belgium's and a quarter in France and the UK.

But there are indirect effects as inter-bank insurance and lending unravels, and that wipes out 100% of German banks’ core tier 1 capital.

Belgium's left with only 7%, France with 25% and the UK with 50%. Britain would take a hit from Ireland in particular, but RBS and Lloyds Banking Group have already written down a lot of their exposure.

And what about adding Italy and Spain? The figures are eye-watering.

The direct effects would require governments to recapitalise German and French banks with 125% of their current core capital, meaning nationalisation.

But add in the indirect effects, and you find it would require 275% of German banks’ core capital, 270% in Belgium, 225% in France and 130% in the UK.

At that point, Germany is only able (it would hope) to meet the bailout requirements of its own banks, while it is every other eurozone country for itself.

On another FT blog, Alan Beattie writes that:

[...] if the ECB can’t bring itself to bail out Italy direct (sovereign credit risk, no expertise in setting lending conditions) it could in theory, according to Article 23 of its protocol, lend vast amounts to the IMF

The IMF would then set about bailing out Italy (which Megan Greene sees as on the cards (‘bail-in'), as does The Economist to a degree), which at the end of it all – amongst all this information – is better than nothing.

Reached by email, RTE's Paul Cunningham said, in answer to the question “Do you have any hope that the ECB might use its position as a central bank to encourage growth instead of austerity?”, that (posted with permission from the sender):

The new ECB President, with the interest rate cut, has illustrated that he's prepared to be pragmatic. There was a question if Mr Draghi might have felt the need
to prove his Germanic credentials by holding off a rate cut until December, on the basis that inflation was above 2%. . The fact that the cut happened at his first meeting
would suggest he is his own man. The debate as to whether or not there ever should have been a rate increase will rumble on for years.

On the wider issue of the ECB's role, it would appear that the President will continue to follow JCT in buying-up bonds in the secondary market, but not in the volume to
alleviate the crisis. There is nothing to suggest that Draghi is prepared to allow the institution become the Lender of Last Resort. In my view, this can only change when
Germany changes ie when the crisis develops to such an extent that the German taxpayer is faced with the ultimate crisis – if we stick to our principles on fiscal control,
the euro collapses.

It's often argued that when Europe is faced with a crisis, it needs to stand at the brink before the deal is done. This time it seems to need Germany to stand at the cliff edge
- if the euro goes, the DM will return, and – immediately – it's export led economy will be in danger. Who will buy their goods when the price has ballooned due to the DM?
Sooner rather than later, deeply-held principle is about to crash against the reality posed by the volatile bond markets.

This post is part of our special coverage Europe in Crisis.

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