European Domino Theory.
Brexit has opened a Pandora’s box of threats to the European Project.
Here’s how the dominos might fall.
Assume for the moment that Brexit goes ahead and, hypotheitically, the already powerfuly eurosceptic leaders of Italy call for an Exit referendum for that beautiful but politically divided country.
The call would of course not lead to an overnight decision to leave. That would require a further period during which the already extended Italian economy would be weakened and uncertainty increased. Investment would drop at once – as is happening right now with the British economy facing the prospect of its leaving the Union by March 2019.
As the decision date approached, financial types would move their deposits from banks in Italy, the new exiting country, into a safer place – probably the United States. No one wants their funds to be suddenly switched from the relatively powerful international Euro into a new national currency when there is ample evidence that the Exit was intended to devalue the local currency and help the weak economy survive.
A vicious cycle would start.
The referendum economy, weakened by the prospect of its exit, would suffer immediate additional pressure on its shaky over indebted position. The default rate would rise, and in turn lead to a further deposit flight. A classic run on the banks would begin.
As part of the West’s achievement over the last few years the banking system has become intertwined. One bank’s debts, one nation’s debts are no longer their’s alone. They are shared amongst many sister banks – and nowhere is the system more intertwined than in Europe. Italy’s debts, already dangerously high at 130% of GDP are parcelled out to banks in Spain, Portugal, Cyprus, and banks in most other member states.The banking turmoil would not be limited to the exiting nation’s banks. The contagion would spread to commercial banks all over Europe.
There have been banking crashes before and they have been resolved. But the challenge today is made much harder by the lack of trust, international cooperation or coherence of western foreign policies. Indeed we could say those qualities are at their lowest level in decades, sunk beneath polarising, populist and in many cases myopic political discord.
The present, already treatening lack of liquidity, the growing and already crippling levels of debt faced by many EU member states, only makes the challenges ahead more real and the vicious cycle more intractable. Furthermore the market’s embrace of new linked and fast moving vehicles – algorithms, ETF’s, Hedge Funds et al – mean the market participants all see the same market moving factors at the same time and they see it quickly. This creates an immediate one way street – mass buying or mass selling with the other side of the trade missing. In such an extremis the market will find it hard to make a bottom; market makers wil sign off; the stock markets will crash.
The European Union has reached too far to be played with lightly. Brexit is already a step too far. The UK has to reconsider. Any further EU exits will likely lead to a recession, plummeting asset values and a banking collapse.
Have a good day, James