How would a break-up of the euro affect the rest of the world?

20 June 2012

A partial break-up of the eurozone, with the weakest economies leaving and the core holding together, could be part of the solution to Europe's problems, rather than the disaster that many assume. As such it would ultimately be positive for the rest of the world too.

Initially, though, the uncertainty and disruption is likely to cause a deep recession in Europe and undermine growth elsewhere.

Suggestions that the global fall-out could be 'even worse than Lehmans' should prove wide of the mark, but the main risks over the next year or so would lie on the downside.

Break up

We first concluded nearly two years ago that the eurozone would probably break apart within five years and identified Greece as the prime candidate to leave first.

Indeed, our economic projections, as well as our forecasts for global financial markets, commodity prices and the European property sector, have long been based on the scenario of a partial break-up.

In particular, we expect a prolonged recession in the eurozone. Even a relatively orderly break-up of the euro would create significant uncertainty and disruption, which could drag on for several years.

There would still be the risk of more chaotic outcomes, perhaps involving the exit of Spain and especially Italy, and even a complete break-up where the euro disappears entirely.

The impact on other countries will also depend on their trade and financial links with the eurozone, as well as the initial health of their economies.

Taking all these factors into account, the recovery in the US should now be robust enough to survive a shock that would tip over a weaker economy such as the UK or Switzerland.

The ability of local policymakers to offset external shocks is also important and should help to cushion the blow for many emerging economies, particularly in Asia, although there is much less room for policy stimulus in the developed world.

Global impact

The global impact should still be less bad than that which followed the fall of Lehmans. For a start, the economic fall-out should be relatively localised. As such, euro break-up could be more like the Asian financial crisis of 1997-98: very serious at the time for Asia as a whole, but with limited effects elsewhere.

The break-up of the euro would also be much less of a surprise than the fall of Lehmans and the financial impacts should become visible more quickly.

Nonetheless, the uncertainty created by the failure of the monetary union would surely be another reason to expect the global recovery to disappoint - for a year or so at least. Europe should eventually be better off without the euro as we know it today, but 'all's well that ends well' surely won't be the first thought of the markets.

Julian Jessop is the chief global economist at Capital Economics

This article was written for our sister website Money Observer

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