4 Ways the Euro Could Fail

All courses of action appear to lead to an eventual financial crisis of some sort. But moderate progrowth policies are the best bet to minimize the damage

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The euro will not die overnight, but it seems increasingly unlikely that the common currency will survive in its present form. European countries and international financial institutions insist that they still expect the euro zone to remain intact, but they are already preparing contingency plans for some sort of breakup. The European Investment Bank, for example, recently required Greek borrowers to agree to a mechanism for repaying loans if Greece abandons the euro.

No one knows, of course, precisely when a fatal euro-zone crisis will occur or exactly what might trigger it. And although the ultimate failure of the euro would cause immense economic and financial shocks worldwide, in the short run the U.S. economy might actually benefit. International investors are already pulling their money out of the most troubled European countries and moving it to safer havens. If the euro zone itself breaks up, lots of that hot money could pour into U.S. markets. Over the longer term, though, the specific impact will depend on how the euro zone unravels. Basically, there are four scenarios, listed here from most to least likely in the short run:

France and other countries persuade Germany to agree to progrowth policies.
Germany has consistently been the strongest advocate of restructuring and austerity as the key to solving Europe’s financial problems. But one by one, Germany’s economic allies are running into political resistance to those policies. The collapse of the Dutch government has made it difficult for that country to meet its budget targets. And in France, Socialist François Hollande is very likely to win Sunday’s presidential election. He has been calling for more progrowth policies, which has provoked consternation in Germany. But the balance in Europe has shifted, and Germany may have no choice but to go along with more spending — and more borrowing — by national governments. In the short run, that would help Europe’s economies by reducing unemployment and limiting the severity of any recessions. But additional borrowing will also contribute to the debt load that governments have to carry.

Outlook: Some progrowth policies will likely be adopted, but they would only postpone, rather than solve, the euro-zone crisis. To the extent that stimulus results in additional debt, any eventual financial crisis might be worse.

(MORE: Italian Prime Minister Mario Monti: The Most Important Man in Europe)

Austerity policies force most of Europe into recession.
Germany may pay lip service to the importance of economic growth but continue to promote austerity. Trouble is, a dozen European countries are now in an economic downturn, including Spain, which officially went into recession earlier this week. In the long run, financially troubled countries need to trim their spending, raise taxes, bring down their labor costs and limit their borrowing. But cutting so fast that a country goes into recession can actually make it harder to reduce debt as a percentage of GDP — because the GDP is shrinking. If Germany prevails and limits growth policies to a little window dressing, financially weak countries may eventually become unable to sell new bonds at interest rates they can afford or voters may refuse to keep supporting austerity policies.

Outlook: A greater likelihood of a widespread recession that spreads to the U.S. and heightened risks of government-bond defaults. This could be the most disruptive scenario, combining economic slowdowns with big shocks to the international banking system.

(MORE: Why We Should Worry About Spain’s Economic Pain)

The weakest countries get pushed out of the euro zone one by one.
If everything continues on present course, then the weakest euro-zone countries will have to offer higher and higher interest rates to sell their bonds, and eventually they will no longer be able to afford to stay in the euro. Greece would probably go first, which would fuel speculation about Portugal, Spain and even Italy. In turn, that would likely push interest rates even higher for those countries, creating a vicious circle.

Outlook: Less likely in the short run, but hard to avoid eventually if nothing changes fundamentally. How painful would it be? On the minus side, countries leaving the euro zone one by one would cause a series of shocks to major banks that hold their debt. On the plus side, after countries left, they would be able to set their economies on a course for recovery. Argentina, which had tied its currency to the dollar in the early 1990s, suffered a major recession after it devalued its currency in 2001. But by 2003, its economy was booming again.

The euro zone splits into two separate currency areas.
The most rational solution — but the least likely for political reasons — would be for Germany and a few allies, such as the Netherlands, to leave the euro zone and create their own new currency. The euro would remain the currency of the southern European countries and could be devalued, easing the pressure on them.

Outlook: A recession in southern Europe for a year or so. Banks would still suffer losses on their bonds — but from price declines rather than outright defaults. Theoretically, at least, this would be the best solution and the least disruptive.

(MORE: Why Germany Should Leave the Euro Zone)

There may, in fact, be no ideal solution. In all four scenarios, there is major financial disruption ahead. They differ only in the severity of the eventual crisis and its timing. The worst policies are the most extreme ones: doing nothing, or being purely harsh and punitive. The best would be to try to maintain some measure of economic growth while preventing countries that are already overindebted from adding too much to their borrowing. The most realistic goal at this point may simply be to avoid making matters worse and to try to minimize the damage.

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