Eoin Treacy's view There has been a great deal of loose talk about the Eurozone breaking up over the last few months. I think it is probably correct to assume that this can be considered a worst case scenario for all involved. However, there are some very real issues that will need to be tackled if this scenario is to be avoided.

In normal circumstances, currency devaluation in conjunction with spending cuts and revenue raising exercises are seen as the logical solution to a debt crisis. Default really is a final option because of the effect it has on a nation's ability to borrow subsequently. The UK has implemented all three of these measures since 2008 in an effort to avoid a deeper sovereign debt crisis and has so far succeeded in keeping its AAA rating.

The Pound fell aggressively during 2008 to test the old 2 Deutsche Mark level before finding support. It now appears to be forming a base. The devaluation option is not currently open to countries such as Greece, Portugal, Ireland, Italy or Spain. I posted proxy values for legacy Deutsche Mark cross rates for a number of troubled Eurozone legacy currencies in Comment of the Day on September 30th. The Drachma, Escudo, Punt, Lira, Peseta and Franc all trended lower against the Deutsche Mark through the 1980s and ‘90s. Most strengthened somewhat prior to the final peg at which they entered the Euro. One has to question what has happened to assume that these countries have mended their ways and that if their currencies actually existed that they would not be substantially weaker than the Deutsche Mark.

I grew up in Killarney, the tourism capital of southwest Ireland. In the early ‘80's, when the Punt fell to parity with the US Dollar, fortunes were made. Americans flocked to Ireland seeking to connect with their roots. Tourists purchasing 30 or 40 hand-knit Aran sweaters at a time were commonplace. Our whole extended family came to visit; more than 50 people in one go. The weak currency greatly improved the country's terms of trade and improved competitiveness. At today's exchange rate the value of the old Irish Punt relative to the US Dollar is close to $1.65. In a freely traded environment, that would be a lot lower. Here are charts for the Drachma, Escudo, Lira, Peseta and Franc against the US Dollar. (Also see Comment of the Day on November 23rd 2010).

A number of Eurozone countries have had massive austerity foisted upon them. Not without good reason following a decade of profligate spending and tax cuts. However, without currency devaluation the prospect of a growth led recovery is dim. Revenue raising and spending cuts will need to share the total burden for recovery. Competitiveness will be re-attained over time but how patient increasingly restive populations are is becoming a more urgent question.

Debt servicing is taking up an increasingly large part of national budgets. A decade of low to no growth is in prospect for more than a few countries, if they remain part of the Euro. If they leave, the short-term consequences would be dire with a loss of savings, capital controls and bankruptcies among some of the foreseeable consequences. However, the medium-term prospects would potentially be more alluring since the competitiveness of exports would be greatly improved almost overnight. If default is to be avoided they will need to write down, defray, extend the maturity, lower the interest rate or default on at least part of their debt.

The EFSF was set up to purchase the bonds of troubled nations but does not have even close to enough capital to make a meaningful difference now that Italian and Spanish spreads have widened. The ECB has begun to issue unlimited quantities of 3-yr bonds and is accepting peripheral debt as collateral. This should help to lower bond spreads as banks pick up the arbitrage between the two assets. The program will have to be considerably extended if further upward pressure on spreads is to be avoided. The ECB will as a result have to increase the size of its balance sheet which is analogous to quantitative easing. It remains to be seen to what extent it is willing to do this.

With slowing growth across the currency union the ECB should feel justified in such action since it is in line with its inflation target of 2% and would help to avoid deflation. The Euro continues to decline and while somewhat oversold in the very short-term a sustained move above $1.40 would be required to question medium-term scope for US Dollar outperformance.