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The Eurozone Endgame: Four Scenarios
By Peter Boone and Simon Johnson

In the aftermath of the Irish bailout, the German proposal for a
future sovereign and/or senior bank debt restructuring mechanism
within the eurozone makes complete political sense to the electorate
in stronger European countries. They do not want to write “blank
checks” to weaker countries and to out-of-control financial
institutions going forward; creditors to countries that run into
trouble will face likely losses.

While the details of this “burden sharing” approach remain to be
hammered out (after Sunday’s announcements), there is no way for
German or other politicians to backtrack on the broad strategic
principles. But once this arrangement is in place, say in 2013 or
thereabouts, all eurozone countries will (a) be able to sustain less
debt than has recently been regarded as the norm, and (b) become
vulnerable to the kinds of speculative attacks in debt markets that we
have seen in recent weeks – to reduce funding rollover dangers, they
will all need to lengthen the maturity of their outstanding debt.

The end point is clear. Last week the markets began to work backwards
to today’s debt profiles; major disruptions still lie ahead.

Ultimately, there will be a eurozone will greater shared fiscal
authority, a common cross-border resolution authority for failed
banks, and likely greater economic integration. But there are four
scenarios regarding who ends up in that eurozone – and how we get there.

First, as officials hope, the IMF bailouts for Greece and Ireland may
work – by stopping the panic and reassuring the investors that there
will be enough growth to make even those debt burdens sustainable.
This seems most unlikely, particularly given what we have seen of the
IMF package for Ireland so far.

In this scenario, everyone can continue to stay inside the eurozone.
The debt profiles of Greece and Ireland would remain vulnerable, as
would slow growth in Portugal and whatever Spanish banks are hiding in
their so-called “stress tests.” Germany agrees to foot an open ended
bill because its leadership becomes scared of the consequences. The
ECB buys a lot of bonds, one way or another.

Second, there is the current market consensus that a package of IMF-
European Union support for Portugal and perhaps Spain would truly
stabilize the situation. This consensus is fragile – and perhaps more
wishful thinking than anything else – but likely to motivate official
efforts in the week ahead. But this is what we call the Maginot Line
Illusion, i.e., an idea that ignores the potential for trouble to jump
to other potentially weaker eurozone countries, such as Italy, France
or Belgium.

In this scenario, Greece probably leaves the eurozone and restructures
its debt. The Germans say “Greece should never have been admitted;
this was the original and only mistake.” Ireland stays in the
eurozone but many of its citizens emigrate. There could be
significant grants from Germany and even from outside the eurozone,
depending on how much fear spreads around the globe.

Third, there is the thoughtful view of Willem Buiter – currently chief
economist at Citigroup and still a brilliant critic of the global
financial system. In a presentation circulating last week (not
publicly available), he predicts “three or more sovereign defaults in
the next five years.” His logic is impeccable – once it is easier to
restructure debts, the temptation is to do exactly that; the market
knows this and so brings everything forward in time.

Fourth, we have the unthinkable – nicely articulated by the Financial
Times’ Lex column on Friday. Divide the eurozone into “relatively
prudent” and “relatively imprudent”, in terms of fiscal policy.
Adjust that for the forward-looking ability to run a primary surplus
(i.e., can a country run a budget surplus on a pre-interest basis,
needed to pay down the government debt if under pressure.) Adjust
this further for off-balance sheet losses incurred by a country’s
banks in the “extreme stress” scenario that begins with the default on
senior Irish debt guaranteed by the sovereign – another “Lehman moment”.

Now the eurozone (more likely, some kind of Neue Deutsche Mark, NDM)
becomes Germany, the Netherlands, Austria, Finland, and a few smaller
countries. Italy is out – even though northern Italy should remain,
two currency zones within one country probably does not make sense
(sorry Catalonia).

In this scenario, France is the interesting case. Does France leaving
the eurozone break the Franco-German alliance that has underpinned
European integration since its inception?

Even this extreme scenario is not so bad for political stability and
economic recovery. The weaker peripheral countries will be damaged
for a generation, but European integration is about more than
attempting to share a currency between countries with divergent fiscal
policies and no convergence in productivity.

The NDM area will do well; in fact, growth there is already strong –
they will probably want to raise interest rates soon. The rump
eurozone will flounder but the positive effects of exchange rate
depreciation will be rediscovered, at least for those without too much
debt.