The worst case scenario

The never-ending euro zone crisis has been described as both tedious and terrifying. But it is worth looking at the end game, what will happen if it all goes wrong. Right now, we are waiting for the European Central Bank to step in and assume its lender of last resort responsibilities. That is to say, that it boldly enters the financial markets and buys enough Greek, Italian, Spanish, Portuguese, Irish bonds to drive their yields down to affordable levels. The ECB, for some reason still scarred by the Weimar hyperinflation of 1923, is loath to bail out the profligate southern European nations and requires the political cover of believable pledges that the PIIGS will restrain their spendthrift ways before it will open up its wallet.

Let us imagine it does not believe their promises and stops buying their bonds. Private investors, already fleeing PIIGS sovereign debt, would find no buyers. Everyone would be selling, no one would be buying, yields would go through the roof. Nations roll over their debt all the time. Imagine if you had to pay off your entire mortgage tomorrow and no bank was willing to extend you a credit line. Unless you had lots of other liquid assets stashed away, you would not be able to avoid default. So it is with Italy and Spain. Without the ability to sell new bonds, they cannot repay maturing bonds as they come due.

If the ECB steps out of the market, the PIIGS cannot roll over their debt. If they cannot roll over their debt, they default. Right now, German, French and British banks own mountains of southern European sovereign bonds. If these nations default, the value of their debt on bank balance sheets plummets. Since sovereign debt has been considered “risk free” by bank regulators, banks back these loans with almost infinitesimal quantities of capital. So if the PIIGS default, many banks equity will be wiped out. That is to say, their liabilities (what they owe depositors) will exceed their assets (the value of the loans they own) and thus they will be insolvent.

This is where it gets ugly. We assume that putting money into the bank is merely hiding it under a more convenient mattress but actually what we doing when we deposit funds into our account is lending money to the bank. We imagine our money is safe, that we can withdraw it all at will. But when a bank becomes insolvent they no longer have enough assets to repay you when you wish to redeem your loan to them. You put your card into the ATM and nothing comes out.

Government guarantees of individual deposits have inured us to the possibility of bank failure. If the bank goes down, the state steps in and the taxpayer replaces the funds that the bank has lost. But, since our scenario begins with sovereign default, Spain, Italy, Greece will not have the funds to make depositors whole. Savings in the southern periphery may well just disappear. German, French and British depositors whose banks become insolvent due to the collapse in value of sovereign bonds will presumably be bailed out by their own governments.

Almost none of us have experienced this sort of systemic failure of the financial system and so we imagine somehow we will come out of it all right. In 1914, Europe hadn’t experienced a major war in nearly a century and so the politicians blundered optimistically into disaster. If the ECB does not take on the mantle of lender of last resort, I do not see how at least some of the PIIGS do not default. If Italy and Spain are not able to roll over their debt, I do not see how we will be able to avoid serious bank failures. But I cannot even begin imagine what will be the repercussions if millions of hard working southern Europeans lose all their savings, if ATMs all over northern Europe stop spitting out cash. I don’t want to find out. I hope to God that Merkel, Sarkozy, and Draghi share my fears.