All Fall Down? Worst-Case Scenario for Global Economy Following Possible Greek Exit from the Euro

Oh boy.

It's drama day today. All day, heh.

From Daniel Altman, at Foreign Policy, "The Worst-Case Scenario for the Global Economy":

Let me start by saying that I have no idea what the worst-case scenario looks like, as indeed no one does. Because of unexpected events — black swans, unknown unknowns, or, to use the term of the moment, Knightian uncertainty — it’s impossible to know just how bad things could get in the global economy. But a few dominoes could fall that might make things very uncomfortable in the markets, and it’s worth considering what the world would look like then.

The most obvious risks are in the eurozone and China. If Greece defaults and eventually has to abandon the euro, the currency’s sheen of invulnerability will disappear. The impossible will have become possible, and investors will be forced to consider the fact that other countries — Portugal may be next in line — might someday exit the eurozone as well.

Uncertainty about the underlying value of the euro will increase dramatically. There will be no way to know what the euro or euro-denominated securities ought to be worth if the makeup of the eurozone itself is unpredictable. Central banks built up euros as a counterweight to dollars in their reserves for years; that trend, already in reverse, could turn into a swan dive. Onetime hopes of making the euro the primary currency for financing global trade have already evaporated, as the renminbi moved into second place behind the dollar two years ago.

All other things equal, though, Greece’s exit will make the euro more valuable. Countries with weaker fiscal positions and demand for securities only serve to dilute the strength of Germany, France, and the other euro stalwarts. But the appreciation of the euro could hurt exports from those same countries, eroding the scant economic growth they’ve been able to achieve — and they’re much more important to the global economy than Greece.

Now throw in the bursting stock-market bubble in China. Companies there have used high stock prices to pay off debt through new public offerings. But investors have borrowed hundreds of billions to finance their portfolios, pushing prices still higher. If the markets crash — and even a loosening of rules on margin trading hasn’t been able to stop their recent slide — free-spending companies will have garnered an undeserved measure of solidity at the expense of millions of Chinese households. Billions in private saving will have financed a raft of pointless projects, destroying wealth and distorting incentives at the same time.

The global implications will be equally bad. Many financial institutions have undoubtedly bet against the Chinese markets, but those that held onto Chinese securities will be forced to pull back the riskier assets in their portfolios. Any contagion of Greece’s problems in other less-creditworthy countries will be magnified. Meanwhile, Chinese investors will have to sell their holdings abroad to cover their margins and losses at home. Major markets will drop, except for the beneficiaries of the usual flight to safety.

Perhaps more importantly, Chinese demand for imports will also decline — not just because of the disappearance of wealth, but also because the dip in the markets will depress the value of the renminbi. Along with Australia, Hong Kong, and Mongolia, a dozen countries in sub-Saharan Africa send at least a quarter of their exports to China. So do Chile, both Koreas, Oman, and Turkmenistan.

For quite a few of these countries, a drop in exports will pose a difficult challenge...

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