Europe, with its tens of religions, hundreds of mutually exclusive cultures and millennia of hatred, was at the centre stage of the bloodshed that took place during the first two World Wars. Will history repeat itself if the Euro breaks? UBS hints at it

The Eurozone debt problem is turning into a big concern. Swiss global financial services company UBS AG in a report has made a very bold and shocking statement. It says, “If most observers agree that a Eurozone break-up significantly increases the risk of widespread economic and financial mayhem... Reasonable people don’t play Russian roulette. So why are some economists suggesting that Europe should?”

In September, UBS’ economics team of Larry Hatheway, Paul Donovan and Stephane Deo had outlined the costs of breaking up the Eurozone. It said that the combination of cascading cross-border defaults, collapsing banking systems, soaring risk premiums, and currency dislocations would result in losses approaching 20% of the gross domestic product (GDP) for creditor countries and 40% of GDP for departing debtors.

On revisiting this, Mr Hatheway said he feels the estimates were probably conservative—the true costs could well be higher. That is because once Europe (and the world economy) finds itself in a depression; policy probably could not arrest the decline. Broken financial systems and ruined economies are the stuff of prolonged deflation or worse. In addition, it is by now abundantly clear that even unconventional macro-policies cannot deliver results if the financial system is in tatters, he said.

The report reminds everyone that anything but a ‘fix’ to a system that was broken from the very beginning would be a catastrophe. The Eurozone was flawed from the start. Wrong countries joined and the Euro area lacks the appropriate policy framework to deal with its imbalances, lack of growth, and internal inflexibility. “Break-up runs the risk of becoming one wretched scenario. Sadly, however, it can’t be ruled out, just as it would have been improper to rule out the horrors of the first half of the 20th century before they happened,” Mr Hatheway said.

He said that the unfolding Eurozone crisis is not something to be taken lightly. The consequences of policy action are material, not just for the 330-odd million residents of the Euro area, but assuredly for the world economy and financial system, as well. The crowd across Eurozone is saying that Greece, which is into huge debt, should leave the zone. Since the euro was introduced, Greece has raked up external liabilities (cumulative current account deficits) of nearly $300 billion, just over 100% of its GDP.

Mr Hatheway said, “The biggest reason why the ‘it’s only Greece’ narrative is naive and dangerous is that it almost certainly would not be ‘only Greece’. Once one country leaves the Eurozone, residents in other ‘at-risk’ member countries would plausibly conclude that their country might be next to go. Logic dictates they would send their wealth abroad, resulting in a run on their domestic banks, precipitating a collapse of their financial sectors and economies.”

There have been some suggestions of breaking the Euro and allowing countries to come out with new currencies as contingency planning. “Contingency planning is prudent. But just what contingency are we planning for? In a break-up, new currencies will be introduced. But will they trade freely? Probably not. As we noted in our original piece on the costs of break-up, it is highly probable that capital controls would accompany exit. Spot, forward, futures, swaps, options and other currency derivative contracts might not even materialize, or perhaps only for limited current account transactions.”

“Companies preparing plans on how they might manage multi-currency cash flows in a post-Eurozone world might be advised instead to pay attention to the risk of not getting paid at all, never mind in which currency. Counterparty risk— bank-to-bank and company-to-company—would soar as defaults mount.”

“Bank risk management teams would be similarly advised not to ask how far new currencies might depreciate or how high risk premiums might rise, but whether the bank would survive a collapse of the payments system, a run on deposits, and widespread default on assets,” the chief economist of UBS said.

Break-up runs the risk of becoming one wretched scenario. Sadly, however, it can’t be ruled out, just as it would have been improper to rule out the horrors of the first half of the 20th century before they happened. “But it is very hard to see break-up as a solution. Let’s hope Europe’s politicians and policymakers agree and take action this week to fix what is broken before it all really breaks up,” Mr Hatheway concluded.