Apocalypse now? - The nightmare scenario for the eurozone

What happens if the eurozone debt crisis remains unsolved? You don't want to know, says Vince Cable. Still curious? Ben Chu imagines the nightmare scenario

the Independant,

12 November, 2011

It is late 2012. Somewhere in the troubled eurozone periphery, perhaps Greece or Italy, a technocratic government collapses after imposing unprecedented levels of austerity for 12 months.

Parliament is dissolved and fresh elections are called. In the tumultuous election campaign, a new party, led by a charismatic unemployed taxi driver with no political experience, emerges as an unlikely front-runner. And against all expectations, this new force routs the discredited established parties and takes power.

The taxi driver's party promised to do things differently in the campaign. And in office, it is as good as its word. The new prime minister refuses to work with his eurozone partners, whom he blames for enforcing the austerity that has led to a doubling of unemployment over the past year. And against the advice of civil servants, he takes a unilateral decision to repudiate all the country's sovereign debts, quit the eurozone and restore the old pre-euro currency.

Though this bold move is initially cheered by a weary population, it turns out to be a short cut to ruin. Some businesses in the country experience a brief boom as the new national currency falls 90 per cent in value against the euro, making national exports instantly more competitive. But the beneficial effects of this devaluation are soon swamped by financial chaos. People discover that the savings in their domestic bank accounts, which have been converted into the restored national currency, have also effectively plummeted in value, wiping out much of their remaining wealth at a stroke. Individuals and companies also have debts that they owe to European banks which are still denominated in euros. After devaluation, the interest repayments soon become unsustainable. The result is a cascade of defaults.

The government is in financial trouble, too. Still spending more than it collects in taxes, the administration orders the central bank to print as much money as it needs to pay public-sector wages. Before long, inflation is running at 20 per cent and people's savings are soon wiped out utterly. People lose faith in the value of the national currency and a barter economy develops. Austerity has been replaced by anarchy. Finally, the government of the taxi driver falls after failing to reduce unemployment, and the International Monetary Fund steps in to run the country.

Meanwhile, a wave of contagion hits the rest of the eurozone. Several banks across the continent, which hold the debt of the nation that repudiated its debts, implode. Despite passing numerous official stress tests, they turn out to possess insufficient capital to absorb the losses arising from a eurozone sovereign default. Governments hurriedly nationalise those banks to prevent ordinary depositors' savings being wiped out. But the debt-servicing costs of other weak eurozone governments continue to shoot up as burned investors panic about the likelihood of further sovereign eurozone defaults.

The newly appointed German president of the European Central Bank, Jürgen Stark, refuses to buy sovereign bonds to support distressed governments, insisting that to do so would be to unleash a tidal wave of inflation across the continent. Eventually, the strain becomes too much. Other weaker states default on their debts and crash out of the eurozone. This results in more bank failures in stronger countries and more nationalisations. But these bank rescues ruin the public finances of France, which was long ago downgraded by the credit rating agencies. With this crucial pillar of the eurozone damaged, the entire single currency breaks apart and national currencies are reintroduced.

Capital floods into Germany, looking for a safe home. This drives up the value of the newly reinstalled Deutsche Mark. But this hammers the German export sector. And with the rest of Germany's European customers also slipping into chaos, its exports fall off a cliff in the following months, throwing hundreds of thousands of Germans out of work. The great engine at the centre of the European economy stalls.

Turmoil in the eurozone sends shockwaves through the rest of the global economy. With its major European trading partners collapsing, Britain is plunged back into recession. British banks have to be nationalised as hundreds of billions of euros of lending to eurozone governments and companies goes bad. Domestic unemployment rises above four million.

Banks in America also turn out to be severely exposed to eurozone sovereign debt and have to be rescued by the administration of the newly re-elected President Barack Obama. But the cost of this rescue pushes up US national debt well above 100 per cent of GDP. And even though capital is flowing freely into US government bonds, which are still seen as the world's safest asset, the Republicans in Congress say they will refuse to vote for another rise in the national debt ceiling. Government should be shrinking, not expanding, they argue.

With the prospect of a default from the US government looming, investors start dumping dollars, the world's global reserve currency, sending the international money markets into a new meltdown. Global trade levels plummet. The export-driven economies of China, Brazil and Russia crash into recession. Spending on investment comes to a standstill across the world. The IMF finds multiple nations making claims on its resources all at once. But it does not have enough credit to go around.

World leaders convene a series of emergency meetings. But they are unable to agree on co-ordinated fiscal stimulus measures. A crisis caused by excessive debt cannot be solved by more debt, say Britain and Germany. And the major central banks are still refusing to provide monetary stimulus, pointing to runaway inflation in those nations that left the single currency. Global unemployment rises. Vast makeshift camps of the desperate and destitute are established in the world's capitals. Democracy itself comes under strain in some parts of the advanced world. Anti-immigrant movements seize power in smaller states, preying on people's fear and confusion. Larger nations impose trade barriers to protect their industries from international competition. Global trade networks slowly break down, nations turn in upon themselves and the world enters a slump even more severe than the Great Depression of the 1930s.