Euro split scenarios risk becoming self-fulfilling

A picture illustration shows euro banknotes outside the European Commission headquarters in Brussels November 28, 2011.

LONDON (Reuters) - Mobilising an army takes on such a momentum of its own that a point of no return is eventually reached. So it may be with the euro zone crisis: before long, the slide toward break-up of the single currency might prove impossible to reverse.

Even as global markets rallied on Monday on talk that a grand plan to save the euro was finally taking shape, more and more researchers are squarely broaching the alternative outcome of the currency's disintegration.

Jean Pisani-Ferry, director of Bruegel, a respected Brussels think tank, noted that market participants and real businesses were increasingly pricing in such a break-up scenario.

"It is still hard to think the unthinkable, let alone to work out the details of it, but any rational player has to consider the possibility of it. If disaster expectations build up and a growing number of players start positioning themselves to protect themselves from it, the consequences could become overwhelming," he said in a report.

German banks and exporters would lose out massively from a collapse in the euro, Pisani-Ferry argued.

To head off that risk, he said Germany should offer its euro-area partners a mutual guarantee over part of the bloc's public debt in return for strict debt limits and veto authority for the euro area over a member's draft budget.

"Only boldness will deliver," he wrote.

EXIT GERMANY?

Simon Derrick, head of currency research at Bank of New York Mellon in London, agreed that the final stage of the drama that has consumed Europe over the past two years had arrived.

But he saw a different ending, with Berlin voluntarily quitting the euro in order to protect the credibility of its own sovereign debt. Berlin's failure to find enough buyers at a 6 billion euro bond auction last week drove home the message that the crisis of confidence in the euro had spread to Germany.

A revived German mark would surge, creating fierce headwinds for German exporters. But Derrick, in a note to clients, argued that manufacturers had coped with a strong currency in the past.

As for the hit that German banks would take as the value of their euro-denominated assets slumped, Berlin might find it more cost-effective to rescue its domestic lenders than to bail out the rest of the euro zone, he said.

Back in the first half of 2010, Derrick had concluded that a German exit from the euro was a highly improbable outcome.

"As we approach the end of 2011 and find the same crisis now starting to spiral out of control, it is starting to sound like a rather more credible solution (at least for Germany and its neighbors).

"Maybe the real significance of the fact that European politicians have effectively admitted that it is possible to leave the single currency is that it allows us to ask which nation would be best heading for the door first," he said.

Ansgar Belke, a professor of macroeconomics at the University of Duisburg-Essen in Germany, said scenarios considered inconceivable just months ago may not appear so far-fetched before long, particularly if peripheral countries' economies continue to stagnate.

"As if this were not bad enough, anti-euro bets are today an everyday phenomenon, steadily increasing the probability of breakup," Belke wrote in a report entitled "Doomsday for the euro area."

FIELD OF RUINS

The economic costs of a doomsday break-up of economic and monetary union (EMU) could be high and extremely damaging, especially if a weak country were to secede from the 17-country bloc, while the political costs were too great to be quantified in financial terms, Belke said.

"Nevertheless, the time may come in which only a little additional shock is sufficient to shift the whole EMU project to a new trajectory, forcing its collapse," he wrote.

David Marsh, the author of books on the euro and the Bundesbank, said Europe appeared to be heading for a re-run of 1992, when French President Francois Mitterrand leaned on German Chancellor Helmut Kohl to get the Bundesbank to put aside its misgivings and defend the French franc.

"If the Bundesbank had its way in remaining on the sidelines while the markets sold down the franc, Mitterrand told Kohl, the Bundesbank would be 'the last one standing on a field of ruins'," Marsh said in a commentary for The Official Monetary and Financial Institutions Forum (OMFIF), which he co-chairs.

In the run-up to the next European Union summit on December 9, a similar confrontation was likely between their successors, President Nicolas Sarkozy and Chancellor Angela Merkel, he said.

Marsh said Monday's market rally was based on optimism that a package of measures on economic surveillance, European treaty changes, steps to fiscal union and International Monetary Fund aid for Italy would encourage the European Central Bank to loosen its purse strings.

This was likely to take the form of quantitative easing along the lines of the asset purchases made by the U.S. Federal Reserve and the Bank of England.

"In this case, the ECB would purchase government bonds across monetary union in proportion to member countries' GDP -- meaning that German and French buying would prevail over Italian.

"That might bring some respite to monetary union's weeks of turmoil -- but no one knows whether it would be sufficient to steer Europe toward a solution," Marsh said.

(Reporting by Alan Wheatley; editing by Ron Askew)