Analysis: Thinking the unthinkable -- a euro zone breakup

BERLIN | Thu Nov 25, 2010 10:56am EST

(Reuters) - Contagion spreads from Ireland to Portugal and then to Spain, forcing European leaders to exhaust the $1 trillion bailout fund they set up only half a year ago to defend their ambitious single currency project.

Sniping within the 16-nation euro zone mounts and popular support for the euro erodes as German taxpayers rebel against a series of costly rescues and austerity fatigue in the bloc's periphery reaches breaking point.

Eventually one or more countries decide enough is enough and break away or are forced out, reintroducing the national currencies they used before tying their fate to Europe's audacious economic and monetary union.

Unthinkable only a few weeks ago, a small but growing number of experts now believe some version of this nightmare scenario could become a reality for the euro zone if policymakers fail to unite behind a more forceful strategy for saving the euro and address investor concerns about fiscal and economic imbalances.

Until now, doomsday predictions of a euro zone breakup have come mainly from Anglo-Saxon skeptics, some of whom saw the single currency bloc and its one-size-fits-all monetary policy as fatally flawed from the very start.

Over the summer, British economist Christopher Smallwood of consultants Capital Economics produced a 20-page paper entitled "Why the euro-one needs to break up" and U.S. economist Nouriel Roubini, alias Dr. Doom, predicted euro members would be forced to abandon the single currency.

But as the second wave of Europe's debt crisis gathers pace, engulfing Ireland and heaping pressure on Portugal and Spain, a new group of doubters is emerging. They believe it may be difficult for the euro zone to hold in its current form, even if many think that remains the most likely scenario.

Some, like Financial Times commentator Gideon Rachman, say Germany could bolt if public frustration with bailouts mounts or if Berlin is unable to convince its euro partners to back its controversial plan for a new permanent rescue mechanism.

Dissident academics have challenged the legality of German participation in the Greek rescue in the Federal Constitutional Court. If they won, the impact on the euro could be devastating.

Others see a risk that economic divergence between Europe's stable core and debt-saddled periphery could end up splintering the bloc into a two-tier "Euro-North" and "Euro-South."

Still others believe Germany could engineer the expulsion of euro weaklings like Greece that it feels should never have been allowed in.

"I don't think we'll see a breakup of the euro and Germany returning to the deutschemark, but what we could see is a more homogeneous euro area purged of its low performers," said Domenico Lombardi, a former executive board member at the IMF who is president of the Oxford Institute for Economic Policy.

HUGE POLITICAL WILL

These voices still represent a small minority and few of the skeptics are convinced the euro zone will fracture anytime soon.

Close observers of Europe, and the policymakers charged with defending the euro, dismiss the possibility of a breakup out of hand.