In my previous post, I tried to explain why a Greek collapse (be this in the form of a default or a Euro exit) should not be such a catastrophe to anyone except for the Greeks themselves. The cost of recapitalizing exposed banks would be a fraction of the money spent rescuing the banking system in 2008, and the financial and trade linkages with Greece and the rest of the Eurozone are so meagre that the common currency area should be strong enough to resist one of its weakest members going bust. But of course, that is not the scenario that keeps European politicians awake at night these days. That is Because although a Greek default may appear to be a disaster, a default among one of the Eurozone’s bigger economies – mainly Spain and France – would be economic Armageddon. A scenario like this would dwarf even Lehman’s bankruptcy in the scale of devastation it would unleash upon the global economy, particularly now that governments in the West are too weak to undertake bank bailouts and fiscal stimulus packages like they did back in 2008-09.
But this leads me to the second part of my argument: even the doomsday scenario of an Italian collapse doesn’t hold up to the reality of its economic fundamentals. I’m not saying this means it could never happen. Quite the contrary: if markets believe it will happen, it will happen, all that is needed is to get enough market aversion to Italian debt that Italy’s bond yields are pushed to unsustainable levels. But why should markets believe it? And more importantly, why didn’t markets believe this during the first year of the Euro crisis, when Italian bond yields had been left practically untouched? What has changed during this time?
The answer, quite simply, is nothing. Continue reading