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.

[ad#Google Adsense 336×280-IA]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.

A Clean Break

The first, and cleanest, would be a split between the “strong” countries in the Eurozone – such as Germany, Finland, and the Netherlands – and the “weak” countries, such as Italy, Spain and France. Greece and Portugal would have to split from even the weaker euro.

Of course, this would require intelligent, apolitical management by European authorities, so it’s pretty unlikely.

Even if such a split was well executed, it would have a negative effect on the economies concerned. It would introduce costs and disrupt the global trade balance. Still, after a year or two of slow growth, Europe would recover. And other European economies outside the Eurozone, like Poland, would not be affected. In fact, they might even benefit, as the disadvantage in international trade wrought by their small currencies would be lessened.

The Perils of Printing Money

The second possibility is a disorderly breakup of the Eurozone, which would result from the ECB printing money.

The ECB would default, but Eurozone debt would not default, simply losing most of its value. Obviously, that means a period of extraordinarily high inflation would accompany such a collapse.

Indeed, large public debts can be worked off quite quickly with enough inflation, as my native Britain discovered in 1945-75. Wartime debts were worked down to a manageable level during that period, in spite of a notable lack of budget discipline.

Of course, the losers were small savers like my Great-Aunt Nan, who put her substantial life savings in government bonds at her retirement in 1947 and was more or less penniless by the time she died in 1973.

This approach, solving a government’s debt problems at the expense of the old and powerless, is especially disgraceful, but politicians don’t care about that. In this case, bonds of all types should be avoided, but stock investments in non-Eurozone members would do fine. However, Germany would be traumatized by the inflation and the costs imposed on the economy by the destruction of its savings.

Disorderly Default

Finally, the third possibility would result from the redoubtable German Chancellor Angela Merkel protecting German taxpayers from bailouts and German savers from inflation. In that case, country after country could default, dropping from the Eurozone in a disorderly manner.

The negative wealth effect from defaulting government bonds would make the defaulting countries poor. Additionally, Eurozone non-members would suffer increased competition from suddenly cheap labor in those countries.

Meanwhile, Germany and other strong countries, like the Netherlands or Finland, would do fine. They’d run balanced budgets and gradually lower their state debts. They would probably remain in the Eurozone (or whatever’s left of it), which would gradually strengthen as the dead weight of weaker economies was trimmed.

Truly, a Eurozone split would be bad news – no matter which way it happened.

Germany would survive an orderly breakup and do well in a tight-money default, but fare poorly in a period of hyperinflation. Conversely non-Eurozone Eastern Europe would do well in an orderly breakup and survive hyperinflation, but it would be battered by a tight-money default.

At the end of the day there are no easy answers on this one. The best you can do is to find markets with little economic connection to Europe – and even that’s not easy.

— Martin Hutchinson

[ad#jack p.s.]

Source:  Money Morning