Great Depression 2.0 is the worst case scenario.
Yes, it could happen.
The effect on the rest of the world is likely to be depression.
The eurozone and the EU are not identical. The end of the euro doesn’t change the EU.
Step by step here.
People don’t think Italy will be able to pay its debts.
Italian banks own a lot of this Italian government debt. If Italy can’t pay its debt, then Italian banks lose their money. They can’t pay back deposits on demand.
Italian banks fail. Not one of them. Not some of them. All of them are attacked at once. It’s a country-wide bank run, as people try to get their money safe out of the banks.
Italy is forced to shut down its entire banking system. They can’t allow the whole money system to collapse, so they institute strict “capital controls” – rules that restrict the flow of funds out of banks. Euros can no longer be transferred freely from Italian bank ledgers to other eurozone bank ledgers. Italian bank money is effectively no longer the euro, since it can no longer be exchanged freely. The euro has already lost its first member, and the breakdown of the machine is only just beginning.
(Note: this is all electronic money, which is the majority of money. The actual paper banknotes are another story. They might all be stamped with a big red “NOT A EURO ANYMORE” stamp, at least the ones that aren’t smuggled out. That’s a huge bloody mess in itself.)
The bank panic extends to other periphery countries. The PIGS are hit for sure. They suffer the same bank run Italy has. This is the biggest bank run in history. They’re also forced to stop operations while their respective governments institute capital controls. The euro loses even more members.
German and French banks, the core of the eurozone, aren’t immune. They’re next on the block. At this point, if they haven’t done so already, the Germans will finally relent and allow what’s left of the ECB to save what’s left of the eurozone financial system. After failing to save Italy, they will decide to save their own countries’ banks. (This is worst case scenario talk here. It’s possible they’ll move before this.)
Money is the lifeblood of the economy. The circulation of this money in Europe has stopped. Trillions of dollars are locked up, unavailable, effectively disappeared for the present. With the euro financial system suffering cardiac arrest, the circulation of money worldwide suffers.
Exposed banks fail in London, New York, Tokyo, and everywhere else. The world economy tanks. Depression ensues.
That is what could happen.
This is what road they’re currently on. It not only could happen like this, it will happen like this unless the European Central Bank steps up to stop it. Which they’ve declared, over and over, that they’re not going to do. More money is needed, and they’re the only ones who can provide it. The only thing that’s really stopping the first domino falling is the odd chance that the ECB is lying about its intentions. The ECB is essentially telling the world that they’re going to fiddle while Rome (and the rest of Italy) burns, and the world is thinking that they can’t fucking be serious about that. Eventually, if the world decides that the ECB is honestly committed to its stated policy of negligence, then the disaster will be free to commence. The run will begin.
Is this likely to happen? Well… I don’t got a crystal ball. What the ECB is trying to avoid is awarding bad behavior. They don’t want to bail out countries that will then abuse that bailout by being irresponsible in the future, and thus in need of yet more bailouts. This is called “moral hazard”. It’s a legitimate fear.
The problem is that there will be a massive cry across Europe to stop the financial crisis when they’re on the verge of the mother of all bank runs. If the ECB waits until the last possible second, until the bank run is already commencing, to backstop the system, then they will have zero time to make good choices about who to save and who not to save. If they decide to step in, they’ll be forced to save everybody, without any limits at all, because they won’t have time to distinguish good from bad. If they wait until the last second, then the moral hazard they’re so damn concerned about will be an even bigger concern than it would be if they helped right now.
Right now, it’s different. If they committed themselves to a more expansionary policy – say, committed to returning to the previous trend line in nominal spending – then they’d relieve the stress on the system a bit. It could, maybe, give them enough time to make better choices to reduce moral hazard. But in that case, the Germans would be forced to admit that they have to eat higher inflation. And the Germans hate inflation. In fact, controlling inflation is the ECB’s only real stated job. Now, Germany will have to eat this inflation anyway, one way or another. Once the dominoes start to fall, their resistance to backstop the system will vanish immediately. They’d be happy to backstop the system if their own banks are on the line. And their own banks will be on the line. They’re going to eat that inflation, one way or another. They just haven’t admitted that to themselves yet.
If you want a good historical overview of dominoes falling, you can look at the gold standard during the Great Depression. Once countries started devaluing their currencies (dropping their gold pegs), then other countries had to follow suit. It will be a similar deal this time, with promises to tolerate inflation in order to save the system. Either they backstop the whole system before countries break off from the euro, or they backstop their own system after countries have already broken off.
Before would be much better than after, but they seem committed to see that first domino fall. They’re going to get their wish before too terribly long.