How Bad Could EU Crisis Get? IMF Attempts an Answer

WSJ: Seriously, how bad could it really get? No one knows what the full impact could be, but the International Monetary Fund has tried to guess.

Failure of euro-zone policy makers to tame their growing debt crisis would likely trigger a severe regional economic contraction, force a fire sale of financial-industry assets and trim the growth prospects of major world economies by several percentage points, the IMF says in its 2012 Spillovers Report.

“What stands between the current situation and the playing out of the scenario is the residual public confidence that policy makers will ultimately act to avert the spread of the crisis,” the IMF said in its 2012 Spillover Report.

The report quantifies the potential global effects from problems in the so-called systemic five economies: the euro area, the U.S., the U.K., Japan and China.

If EU authorities don’t act in time, the IMF said output in the euro area could be cut by five percentage points. Further, around two percentage points would be lopped off U.S. growth prospects, and output in China, Japan and the rest of the world would take a hit of around 0.5 to 2.5 percentage points.

The IMF said its simulation models may even understate the potential impacts because they don’t, for example, take into account the fact that effects could be amplified amid a weak banking system and feedback loops.

Last year the IMF said that, provided the debt crisis doesn’t spread from the peripheral euro area countries, any stresses in the monetary union would only have modest impacts on the rest of the world.

But euro-debt tensions are now pan-European in nature.

“Spillovers from a failure of policies to get ahead of the crisis would thus be widespread,” fund staff said.

As Greece increasingly heads towards default and Spain’s borrowing costs hover near unsustainable levels, euro officials are struggling to move ahead with a banking union and other integration policies the IMF believes are essential to douse their debt fires.

The IMF assumed in its scenario that borrowing costs for ailing members such as Italy and Spain would rise around 300 basis points, but the fund said around half of the shock has already materialized.

“The other half of the shock would obviously strain those countries and possibly cut off market access,” the report said.

Should the euro-crisis scenario fully materialize, the fund said central banks could damp damaging spillover impacts by coordinating unconventional policy action.

Turning to the U.S., the fund quantified the potential effects if the White House and Congress don’t reach a deal to prevent the “fiscal cliff.” In one model, the IMF said stock prices could initially plummet 15% and cut U.S. output by up to five percentage points.

And if political gridlock in Washington continues to prevent a credible medium-term plan for cutting the debt and deficit, long-term Treasury yields could see a 200-basis-point spike that would shave five percentage points off domestic output and 2.5 to 3.5 percentage points off output in the rest of the world.

The likelihood of such scenarios may be low, but the IMF said they are worth exploring because the impact on the world economy is potentially “very large, not the least on account of their transmission via financial markets.”

By Ian Talley