What now for the EU and the euro?


EURO DEAL:The 14th European debt crisis summit in 21 months concluded in yet another joint communiqué from European leaders that raises many awkward questions, even while it attempts to answer them.

Steps to success

‘Merkozy’ seal the deal

After announcing a sketchy outline of a deal in Brussels, Angela Merkel, Nicolas Sarkozy et al iron out the details of a €1 trillion leveraged extension to the euro zone’s rescue fund, the European Financial Stability Facility. There are no further breakdowns in unity or hiccups in the votes of the EU’s national parliaments. The banks’ acquiescence to a 50 per cent writedown on the face value of Greek government debt becomes a formal haircut, with the “voluntary” aspect of the deal avoiding a nasty trigger of credit default swaps. Everyone goes along with the line that Greece’s “default” is not officially a default at all.

Markets respond, with feeling

The post-summit “relief rally” is sustained into something more permanent, as investors accept that the EFSF’s leverage of €1 trillion is enough to ensure that Europe’s biggest wobbly dominos – Italy and Spain – have what Merkel called a “firewall” around their debts. Bond spreads narrow, with the yields on Irish debt falling back to pre-crisis levels, back when no one cared about the cost of sovereign debt. The market seal of approval evaporates doubt about Ireland’s ability to raise finance once its €85 billion pipeline of funding from the troika runs out. It turns out that Ireland really is the poster child for European austerity.

Austerity pressures subside

The new €100 billion bailout that will be granted to Greece early in the new year is enough to shore up the black hole in the Greek economy for the time being, while the EFSF is not so depleted that markets start to fret. Greek debt peaks in 2013, attention is paid to Athens’s need to return to economic growth at some point and the Greeks stop rioting. Ireland, Portugal, Italy and Spain continue with their agreed austerity programmes, but there’s more room for manoeuvre. A firesale of State assets is called off, while political pressure from Germany for further harsh budget cuts eases. Europe’s long-simmering debt crisis cools off.

Positive contagion sweeps the world

Europe avoids a "lost decade", with most economies edging back to growth. A "strong" Merkel is re-elected in Germany, Berlusconi is kicked out as political credibility is restored in Italy, and Sarkozy puts up a decent fight at the French polls. The European Central Bank is obliged to hike interest rates to contain inflation. The US economy is buoyed by the crisis resolution and the Great Recession

Part Two is averted.

China, a "super-creditor" of Europe as a result of its support for the massively leveraged EFSF, assumes a bigger role on the global financial stage. Meanwhile, Ireland's open economy status means Irish exports are among the first to soar.

The Irish start shopping again

Having reacted to Ireland’s economic collapse by “restoring their balance sheets” to less nervy levels, the high savings rates of Irish households start to fall back. Consumers who still have jobs regain the confidence to start spending money, as threats to their personal financial status recede. The retail sector bounces back, as everyone stops bristling at the gall of politicians who have been telling them to spree like it’s 2006, and actually start doing it. Inflation tips up, making the real value of debt seem more manageable. Unemployment rates eventually retreat from their peak, as more jobs are created in the domestic economy.

Ireland pays off its debts

The campaign for Enda Kenny to a Greek-style default deal at the negotiation table melts away, as growth in Irish gross domestic product exceeds even the most optimistic expectations.

The convincing recovery means the Government is able to follow through on its commitment to honour the debt it has drawn down under the EU-IMF deal without introducing further unpalatable budget measures.

Ireland's primary balance moves into surplus in 2014, as recently forecast by the Economic and Social Research Institute.

The premium on Irish borrowing costs reduces sharply and the domestic banks start lending to small businesses again.

New and improved Europe emerges

The euro zone sticks together, with even Greece remaining a member of the single currency, but monetary union now comes with the greater formal political co-operation that policymakers have learned is vital for its operation. Closer supervision of national fiscal policies lessens the risk of a “two-speed” Europe, making it easier for the ECB to fix an interest rate policy that suits everyone, while cross-border regulation of the banking sector is beefed up. The 10 EU members who don’t belong to the euro zone strengthen their links, but stop short of forming a bloc that impedes relations in Brussels. The European project rolls on, but with a raft of new contingency measures in the event of a fresh catastrophe.

Road to failure

The sticking plaster peels off

The saying “nothing is agreed until everything is agreed” proves disastrously true. The baby steps taken in Brussels are followed by giant leaps back, as the deal unravels over crucial details, such as the final size of the European Financial Stability Facility rescue fund and the ECB’s future powers. Separate deal-wrangling with the Institute of International Finance, which represents the banks, breaks down without finalising the rate of private sector participation in Greece. Alternatively, the fallout from the Greek debt restructuring emits larger than expected shockwaves, making the €1 trillion EFSF boost look a bit skimpy.

Europe goes down the wrong road

The 15-page outline of an agreement released in the early hours of Thursday morning does not, as British chancellor George Osborne predicts, put Europe “on the right road”. Instead, markets are spooked by the impasse, prompting a major equities sell-off and widening of bond spreads. The Greek storm shifts to other “Club Med” countries. Italy and Spain – guarantors of earlier bailouts – now look like they’ll need to tap Europe’s rescue fund themselves. Speculators take bets on countries joining Greece in defaulting on their sovereign debts. Greece is forced to exit the euro. Other countries consider following suit.

The banking sector freezes up

As credit markets seize up and the ECB stops acting as a lender of last resort, European financial institutions are left calculating the full scale of their exposure to the Greek economy. Credit ratings agencies race to downgrade their creditworthiness. Caught in a liquidity trap, the shakier European banks collapse – their failure generates further quakes in the interconnected financial system. Major French banks Société Générale and Crédit Agricole, already downgraded by Moody’s, are among the first in the line of fire. The ensuing chaos proves infinitely worse than that which followed the obliteration of Lehman Brothers in 2008.

Era of ultra-austerity sinks in

Spain and Italy are corralled into passing severe austerity measures, sparking political hostility and social breakdown. The Irish government is forced to sell as many State assets as possible. The cutbacks orthodoxy all but kills any scope for economic growth, and instead deepens deficits and creates a spiral of gloom in peripheral euro zone countries.

Makeshift protest camps become permanent fixtures in major European cities, as “a dictatorship of creditors” winds its tendrils across the monetary union. The UK, already in the midst of a fiscal adjustment, reels from the impact of the euro zone’s dysfunction and joins it in deep recession. This in turn exacerbates Ireland’s difficulties.

The ‘real economy’ contracts

Ireland’s export-led economy leaves it more vulnerable than most euro zone countries to the spillover effects of a full-blown banking crisis, as private sector lending comes to a standstill and its export destination markets are left banjaxed. With much of the global economy in the doldrums, Ireland is rendered unable to trade its way into growth, while record-low consumer sentiment is reflected in plummeting retail sales. Unemployment spikes. The bind places Ireland in real danger of a default that, if it went ahead, risks eliminating what’s left of the Government’s economic autonomy for more than a decade.

Ireland belatedly defaults

Ireland admits defeat on the repayment of its sovereign debts, reneges on its commitments under the EU-IMF deal and defaults at precisely the worst time. This forces it to immediately close the gap between the tax revenues earned by the exchequer and the amount that it spends each year on public services. Infrastructure budgets are slashed to zero, while mass public sector layoffs add to the numbers of jobless. Distracted by worsening events in the larger Italian and Spanish economies, and facing the realisation that it will require a financial lifeline of several trillion from new economic powerhouses such as China, European policymakers are slow to come to the aid of Ireland and the grip of the IMF strengthens.

The euro zone endgame plays out

With Germany refusing to be taken down by its weaker neighbours, the euro zone disintegrates in a disorderly fashion. Ireland is among a group of countries to be pushed out of the monetary union in the first stage of its collapse. The Irish pound is reintroduced and linked to a weighted basket of currencies, and while the devalued currency makes Irish exports more competitive, no one’s buying. No longer seen as a convenient gateway to monetary union, Ireland’s attractiveness as a location for foreign direct investment fades. Mortgage interest rates rise sharply. Merkel’s warning that “if the euro fails, Europe fails” becomes a grim reality.