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…and why it has become more likely now: Obviously, we have not reached the end-game yet. However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons. First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other Second, the ECB’s climb-down on its collateral rules regarding lower-rated bonds, which ensures
What are the signposts that would indicate our break-up scenario is in fact unfolding?
* First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.
* Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.
* Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound. If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.
Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.