Eurozone on a 'cliff edge', ready to fall

Recession in the eurozone could trigger widespread sovereign defaults

The eurozone sovereign debt situation is on a cliff edge. This may sound like a statement of the obvious given the chaos within financial markets, but there is a very real sense in which this analogy holds. If sovereign debt default is limited to Greece, then it may be possible to contain the problem. There will be good ways and bad ways of dealing with the problem of Greek default, but Greece is relatively small compared with the total capacity of European financial markets so catastrophe should be avoided. If Spain, Italy, Ireland and Portugal do not default, we just stay on the land side of the cliff.

On the other hand, a debt default involving Spain and Italy – and possibly even Ireland and Portugal – would be a catastrophe. And this is much more likely to happen if there is further recession. Many journalists and financial market practitioners are just calling for political will to be exercised to resolve the crisis. If only the Germans had the courage, it is argued, we could resolve this problem. This is a delusion.

Already 30 per cent of the European Financial Stability Facility is being guaranteed by the countries that are in trouble. The European Central Bank stands behind the EFSF, but this also has its capital provided by the eurozone countries. This situation is like two people going to the bank and admitting that they are both insolvent, but asking the bank for more money on condition that they will guarantee each other's loans. If the eurozone governments in general recapitalise the banking sector in the event of a major sovereign debt write off, then other countries will run into trouble – France being the most obvious candidate. The whole of Europe will stand on Germany's increasing narrow shoulders.

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It has rightly been said that one of the problems is a lack of confidence. One of the things that might help improve confidence is for governments to recognise publicly that they have got too big and to promise to take steps to reduce their size and scope in the years ahead. One has to look very hard to see many signs of this in the UK, let alone on the continent of Europe. It now seems unlikely that defaults by several governments -- not just Greece's -- can be avoided; and on the record to date it is difficult to see how the statesmen in the eurozone are going to manage such a potentially catastrophic turn of events.
Right, the looming recession is the most serious threat to the ongoing rescue operations and the euro as a whole. If more and more lenders to the EFSF become borrowers the rescue operations will push even Germany into sever troubles. The problem is, that many countries did not made their homework – to implement sustainable budget consolidation and to improve their economies by structural reforms. Let’s hope that the looming “fall from the cliff” pressures for emergency reforms. Nevertheless, a second round of banking crisis could already push the euro off the cliff.

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