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Four scenarios for Europe - scenario 3: European ‘disintegration’

Economic Report

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To overview page future scenarios for Europe

  • Cooperation between the Member States deteriorates and collective problems cannot be adequately addressed
  • An economic crisis ensues and unemployment rises sharply
  • The eurozone disintegrates first, followed by break-up of the EU

Keynote: continued weakness and indecision undermines the European Union

The European Union faces numerous challenges, but does not have the decisiveness to really deal with the problems. What consensus there once was now gradually diminishes, until the EU becomes ungovernable and more and more powers are returned to national governments. The EU and the eurozone as we know them now will disintegrate. The result will be an economic and financial crisis that will be quite different from the sovereign debt crisis in 2010. This is because the Member States will no longer agree on a number of crucial issues, there will be much less solidarity for mutual assistance and neither the resources nor the will to deal with a financial crisis will be in place. Such a scenario could unfold as follows.

Brexit degenerates into an acrimonious divorce

The British and the EU are negotiating on the United Kingdom’s departure from the EU. The negotiations do not go well. The uncertainty that this creates pressures investment in both the UK and the eurozone and there is a danger that unemployment will rise again in many countries. In order to keep the British on board, some EU countries want to offer concessions to the UK. For instance, on immigration policy, since this is a sensitive issue in several other countries as well and these countries would not therefore be against the limitation of free movement of people. With this concession to the British, they hope that British membership of the Single Market could largely be maintained. However, this causes serious friction between the East European countries that are against any limitation of free movement of people and some of the core countries that would like to see some limitation. In addition, certain countries will try to use Brexit to improve their own position. The Greeks request debt relief and the Portuguese call for easing of budgetary policy in exchange for room at EU level for concessions to the UK. All the difficult issues therefore surface at once, including the refugee problem, while unanimity between the EU countries declines and therefore the possibility of finding a solution becomes more and more remote. This sparks further anti-EU sentiment and plays into the hands of the eurosceptic parties. The EU is on the point of break-up. The free movement of people (Schengen) will be limited under pressure from new inflows of refugees and concessions to the British. But the EU will not come to a unanimous decision and an economically favourable deal for the British will be blocked.

Euroscepticism on the rise

EU referendums are held in various countries, with majority votes against EU membership. Early elections in Italy are called in 2017. The Five Star movement wins, and with the help of a number of other Eurosceptic parties, succeeds in changing the Italian constitution so that a referendum on euro membership can be announced. The Italian population vote against the euro, since here as well anti-Europe sentiment is boosted by continued austerity, unpopular reforms and a heavy inflow of refugees. Italy feels that it has been abandoned because there is no European solution to the inflow of refugees and some Northern countries even close their borders with Italy. The country unilaterally leaves the euro with immediate effect and introduces the new lira. At the same time, Greece remains in default and also introduces its own currency, the new drachma. The new currencies fall sharply in value. This benefits the Italian and Greek competitive position, but any potential positive effect will be more than undone because these countries lose their access to the Single Market. After all, by leaving the eurozone, they have also cancelled their membership of the EU. Imported inflation and interest rates rise sharply in both countries and there is a threat that the government will remain in default on its debt.

Crisis in the European financial markets

There will be heavy speculation in the financial markets expecting further disintegration of the EU and therefore the eurozone as a result of the Greek and Italian exit. Bond yields in the weaker Member States will rise and the euro will fall sharply against the dollar and the yen. Uncertainty regarding the fate of the eurozone will prompt a new capital flight out of the euro into the dollar, and within the eurozone from the weaker to the stronger Member States, and from weaker to stronger banks. The new Banking Union cannot withstand the systemic nature of the crisis, and various Member States are forced to nationalise their banks on a large scale (in contravention of the agreements made in the European context). As a result of these actions, government debt in these countries increases further. In combination with higher bond yields, this means that the public debt position of an increasing number of countries threatens to become unsustainable. The Banking Union ceases to exist and supervision of the banking system returns to the national supervisory agencies.

Calls for intervention by the ECB via the application of its OMT programme or otherwise increase in intensity. But there are serious divisions within the ECB. As a result of the departure of Greece and Italy, the Eurosystem has already had to book significant losses because the Greek central bank in particular cannot meet its obligations under Target2. Led by the Northern Member States, a majority is against new support purchases and the ECB ultimately does not intervene. It also ceases its existing quantitative easing programme. The weak euro (which by now has fallen 30 per cent in value against the dollar) forces the ECB to raise its policy interest rate in order to prevent a genuine currency crisis. Initially, inflation rises in the rest of the eurozone as well due to higher import prices. The effects on capital markets interest rates in the complex interplay of forces in this scenario are particularly difficult to gauge. There will be divergence between countries, with higher spreads for the weak Member States compared to the core countries and higher risk premiums in general. Based on the ‘relative’ attractiveness of the core countries (and therefore capital flows in this direction), a more restrictive monetary policy and general pessimism regarding future growth will flatten the yield curve in core countries such as Germany and the Netherlands as a result of a decline in long term bond yields.

The ending of bond purchases by the ECB, uncertainty as to whether France still belongs to the group of core countries (as was the case in the previous sovereign debt crisis) and uncertainty regarding the spill-over effects of the exit of Italy and Greece for the other countries (and their government finances), however could mean that the yield curves in core countries like Germany and the Netherlands could initially steepen as a result of higher term premiums.

A new crisis summit fails to turn the tide

A special EU crisis summit is arranged in response to these developments that are disastrous for the EU. This reveals the extent to which relationships have soured and trust and readiness to cooperate have evaporated. After days of talks, it will be concluded that the euro cannot ultimately be saved and it would be better to take action and dissolve it, mainly because there will be no willingness among the wealthier Member States to once again open their wallets. There will then be a transitional period in which the former euro countries introduce their new national currencies. All the former euro countries will institute capital controls to prevent a large-scale capital flight, meaning that money can no longer be transferred abroad. Agreements will be made regarding the new exchange rates immediately after the announcement that the eurozone has ceased to exist. National governments, and businesses as well at a later stage, will use improvised money in the form of IOUs (which will be converted into the local currency on a one-for-one basis). This will be necessary to remove uncertainty and because otherwise businesses, households and governments would not be able to issue any new debt paper. This will lead to a massive bank run because people will think that euro bank notes can be exchanged at a later stage on better conditions for the new currency than balances held at banks. As a result, the maximum amount that customers are able to withdraw from their bank accounts will be severely limited. This will particularly apply in Southern Europe, where the banking system will encounter further problems. Despite capital controls, the new exchange rates fall in the markets, whereby the German ‘euro’ will appreciate relative to the other European exchange rates, but not against other major currencies such as the dollar, the British pound and the Swiss franc. The country will no longer be a safe haven in the international context. The Dutch monetary authorities will strive to link the Dutch ‘euro’ to the German, which means a return to the monetary situation in the pre-euro era.

Disastrous economic consequences

Foreign direct investment (FDI) in Europe will dry up, inflation will rise and interest rates will increase in all the former euro countries, albeit by less in the north than in the rest of the former eurozone. Business investment will contract, unemployment will rise and household consumption will decline. There will be calls for protectionism in France and other countries, whereby the Single Market will effectively cease to exist. Border controls and (non-tariff) trade barriers will be introduced. This will damage the trade of goods and services between EU countries. All this will lead to a deep recession in the European economies. Government spending will rise while government revenues will decline, meaning that government deficits will balloon in all countries. This will in turn put the sustainability of government debt under pressure. More families and businesses will have difficulty in making payments. Internal trade between the Member States in Europe will collapse. Pension funds and investors will suffer heavy losses on their domestic investments, but to a lesser extent on their international investments, because investments outside the former eurozone will rise in value due to currency effects, viz. an appreciation of non-EU currencies. The general increase in interest rates will raise hopes that pension fund coverage ratios can improve to some extent because the present value of their liabilities will decline. Unfortunately, this positive effect will be more than cancelled out by the heavy capital losses they will be forced to incur. The yield curve will ultimately flatten again and become inverse, with interest rates at the long end rising by much less than at the short end.

The common agricultural policy will also come to an end, which at one time played an important part in European cooperation. This will lead to a deep crisis in the agricultural sector in the European Member States.

Box: How the disintegration of the EU will lead to a lengthy crisis in agriculture

In a disintegrated Europe, countries will increasingly go their own way when it comes to agriculture. The Netherlands will look for closer cooperation with Germany and the United Kingdom, its most important trading partners. Dutch agriculture and horticulture will have to absorb big losses, since some of its agricultural exports will disappear and its home market is too small to absorb the extra supply. The prices of dairy products, meat and potatoes will fall significantly in the Netherlands and this will lead to a lengthy crisis in the agricultural sector. The Dutch government will be reluctant to give a helping hand, and instead of focused support for agricultural businesses in difficulties it will refer failing enterprises to the regular social safety net for failing business owners. The crisis will be less severe in countries such as France and Germany, since agriculture in these countries can fall back on a much larger domestic market. With the support of their national governments, they can also perform more strongly in export markets.

Institutional crisis

Europe’s position as a global block will weaken to a huge extent, because there will no longer be representatives of Europe as a whole and the representatives of the individual European countries will make little or no effort to formulate a common interest. The European Parliament and the European Commission will be drastically cut. Brussels will look increasingly like a ghost town. The European Commission will be instructed by national leaders to formulate a new and minimalist European cooperation. This will turn into a dismantling of the existing European Treaty, with most powers being returned to the Member States. This will ultimately centre on a rather rudimentary customs union that will be far less extensive than the Single Market. The European Parliament will have no further purpose and will be disbanded over time. The ECB will have the job of settlement and the monetary and financial unravelling of the currency union. The sharply weaker position of Europe will prompt other countries such as Russia to pursue their own agenda. Russian intervention in its neighbouring countries will lead to serious destabilisation of these countries, especially the Baltic States, Poland and Slovakia, but also in Greece. The United States will no longer see the EU as a complete entity and will only look for further cooperation with those Member States that in its view are important in economic, political or military terms.

Consequences for the Netherlands

As one of the most open economies on the European continent, the Netherlands will be hit hard by a disintegration of the European Union. Its exports will be sharply reduced, not only due to protectionist measures on the part of its trading partners, but also because of its relatively strong currency compared to some of its important European trading partners. This relative currency strength will limit inflationary effects, but the Netherlands will nonetheless enter a new recession. Transit trade will also be hard hit by European fragmentation, whereby the Netherlands will lose its role as gateway to Europe. Sectors such as transport and logistics will suffer, and volumes at the ports of Rotterdam and Amsterdam will decline sharply. The Maasvlakte 2 engineering project (part of Rotterdam harbour) will become a new nature reserve, and Schiphol will see its importance as a European hub significantly diminish. The winding up of the monetary union will lead to heavy losses for the central bank, that ultimately will be passed on to the Dutch government.

Summary of the ‘Disintegration’ scenario

  • The Brexit negotiations do not go well and lead to differences of opinion within the EU
  • Cooperation between EU countries deteriorates further, and anti-EU sentiment rises
  • Some Member States leave the eurozone, and their currencies depreciate heavily
  • Financial chaos: the departing countries remain in default on their government debt
  • The Banking Union falls apart, with some countries being forced to nationalise several major banks
  • A decision is taken to dissolve the euro, and this involves capital restrictions
  • The Single Market disintegrates, leaving only a rudimentary customs union
  • Political cooperation ceases; the European Parliament is disbanded, Brussels becomes a ghost town

Consequences for the Netherlands

  • Economic growth falls sharply due to the collapse of the Single Market and a relative appreciation of the national currency
  • Unemployment rises sharply due to the large decline in economic growth
  • The Netherlands loses its role as gateway to Europe, foreign head offices depart
  • Pension fund coverage ratios decline despite higher interest rates and inflation due to capital losses
  • Large currency loss on foreign assets, especially in the former eurozone

Literature

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Boonstra, W.W. (2012), Conditionele Eurobonds als overgangsregime, Economisch Statistische Berichten, 2 March 2012, pp. 134 - 137

Boonstra, W.W. (2016a), Breaking up is hard to do, Rabobank Special.

Boonstra, W.W. (2016b), De voor- en nadelen van Eurobonds, Rabobank Special.

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Lane, P. (2012), The European Sovereign Debt Crisis, Journal of Economic Perspectives, 20(4), pp. 47 – 66.

Loman, H. & M. Wijffelaars (2016), The eurozone – completing the monetary house eurozone, Rabobank Special.

Mundell, R. (1961), A Theory of Optimal Currency Areas, American Economic Review, 51(4), pp.657 – 665.

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Shambaugh, J.C. (2012), The Euro’s Three Crises, Brookings Papers on Economic Activity, Spring 2012, pp. 157 – 231.

Smit, H. (2016), De Nederlandse land- en tuinbouw heeft groot belang bij de EU, Rabobank Special.

Teulings, C.N., M. Bijlsma, G. Gelauff, A. Lejour & M. Roscam Abbing (2011), Europe in Crisis, CPB Boek 4, published by Uitgeverij Balans, 14 November 2011.

Van de Hei, L. & L. Treur (2016), SME financing in the Netherlands: an increasingly diverse landscape, Rabobank Special.

Wijffelaars, M. & H. Stegeman (2014), European Commission kijkt toe terwijl Europe uit balans blijft, Rabobank Special.

Wijffelaars, M. (2014), Europese begrotingsregels: feit of fabel?, Rabobank Special.

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Author(s)
Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 5128 1405
Martijn Badir
RaboResearch Netherlands Rabobank KEO
+31 88 726 7864
Elwin de Groot
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 1389 2916
Carlijn Prins
RaboResearch Netherlands Rabobank KEO
+31 6 1929 6455
Daniel van Schoot
RaboResearch Netherlands Rabobank KEO
+31 88 726 7864
Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2257 0569
Nic Vrieselaar
RaboResearch Netherlands Rabobank KEO
+31 6 2216 2257

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