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The euro zone's unexploded ordnance is no longer nuclear

THE euro-zone crisis is not solved and is not likely to be solved soon, but the greatest immediate danger has been avoided. Two points worth stressing.

1) The euro-zone economy has some "unexploded ordinance" in it that is likely to explode eventually, but no one really knows whether it is a grenade, a 1000kg bomb, or a nuclear device; what leaders did last week and are doing this week is making sure it is NOT a nuclear device.

Europe still faces a number of vortices that could pull down the euro zone if allowed to get going: the "Greek" austerity-budget deficit vortex, and the "Lehman vortex" that sucked Dexia below water, as per the diagram below.

However, euro-zone leaders seen to have finally rendered the worst vortex inoperable, namely the "Irish" vortex where by shocks pull down banks, banks pull down governments and then the vortex spreads to the next government in line. In this case it would have been Greek restructuring pulling down banks that forced nationalisation that forced downgrades that drove up yields which then made the governments insolvent. As this might rapidly have reached Italy and Spain, the "nuclear" outcome was truly scary—the sort of thing that had Charles Wyplosz talking about 1930s-like outcomes.

The first revelation is that they have now finally admitted that backstopping the banks is absolutely essential, mostly via recapitalisation. I'd guess that they'll flub the job at the EU and G20 summits but that doesn't really matter. They are now at "battle stations" when it comes to the banks, so we won't have a Lehman-like moment that then brings down the world's third largest debtor (Italy). Either national governments, or the EFSF will make sure the banks remain intact regardless. 

The second revelation is that regardless of what they do to scale up the EFSF, it won't be big enough to backstop sovereigns in a way that will prevent contagion. However, this doesn't matter as the ECB will be forced to step in—just as it did in August and for exactly the same reason. Contagion spreading to Italy, Spain, Belgium, Malta, France etc would spell a very rapid and very ugly end to the euro zone. Besides, they have the ready excuse that they employed in August about orderly markets and monetary policy. But not all is for the best in this best of all possible worlds. The law of unintended consequences will be fully enforced.

2) Their half-hearted solution on the banks will almost surely lead to a recession. The most likely outcome is that the bank recapitalisation scheme gives Europe's stronger banks a chance to create a credit crunch instead of taking government money. This is especially true since German banks are resisting both forcible recapitalisation and further write-down of Greek debts. The euro-zone governments are probably going to insist on the former but not on the latter. As the figure above shows, the recession is likely to start up all three of the vortices again, so we'll be back at the drawing board in a few month's time. But at least we'll have avoided a truly historic crisis. Now let's just hope the Greek street plays along with the role assigned to them this weekend. If euro-zone leaders don't do enough to help the Greeks—to make sure they see a light at the end of the tunnel—we may see political chaos and a disorderly default that would severely test my hypotheses that the nuclear- threat has been removed. 

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