Europe Faces A Genuine Economic Depression If The Eurozone Breaks Up

Includes: IEF, TLH, TLT
by: Josh Cohen

After a summer lull as Europeans went on vacation, it now looks as though we are reaching another turning point in the eurozone crisis. On September 12, the German Constitutional Court must rule on the legality of the European Stability Mechanism (ESM), the proposed permanent successor to the eurozone's current emergency lender, the European Financial Stability Mechanism. The German court will rule on whether the newly created ESM would violate German law. Without getting into the technicalities of German law, suffice it to say that a German veto of the ESM would cause chaos in the markets and send Greek, Portuguese, Irish, Italian and Spanish bond yields soaring.

Meanwhile, it appears as though politicians and elite media opinion has actually begun thinking the once unthinkable - that we may indeed see the eurozone split apart. In a recent analysis in the Economist titled "The Merkel Memorandum", the Economist asks whether it might indeed be better to simply allow the eurozone to collapse.

Meanwhile, according to an article in the U.K.'s Daily Telegraph, European Central Bank Chairman Mario Draghi continues to equivocate on whether or not to launch a huge bond buying program, essentially embarking on massive Quantitative Easing to drive down the sovereign bond yields of the eurozone's most troubled members. While it is not stated explicitly, the true focus would be on capping Spanish and Italian yields, as both of these countries represent classic cases of "too big to help and too big to fail".

As the Telegraph article notes, however, the current and former German Bundesbank chiefs immediately lashed out at Draghi's proposal, causing the ECB Chairman to walk back his earlier comments:

"On cue, Draghi has been in retreat in recent days, trying to mollify Teutonic concerns that the eurozone printing presses will be fired up, with dire inflationary consequences. "The ECB will do what is necessary to ensure price stability," Draghi purred. "It will remain independent and will always act within the limits of its mandate."

As I noted in a previous piece here on Seeking Alpha, I believe it is absolutely critical that the ECB embark on a large and sustained program of QE, with a focus on driving down and capping Spanish and Italian sovereign yields.

I am certainly not inherently in favor of QE, but right now, it is by far the lesser of two evils in the eurozone. With the continent about to implode, it is just utterly puzzling to me why the ECB will not function as a proper central bank and act as a lender of last resort.

To understand the risks inherent in a major European economy such as Italy defaulting on - or even restructuring - large amounts of debt, consider the exposure of banks from France and other eurozone countries to Italian debt. Given that French banks are already thinly capitalized, their huge exposure to Italian debt would surely result in the complete and utter insolvency of their banking system.

In my humble opinion, many people are forgetting the lessons of the first Great Depression. While the years 1929-1930 were bad, what truly caused that situation to devolve into a "Great" Depression was the collapse of Austria's Credit Anstalt bank in 1931. While it was just one bank, its collapse threw the markets into utter chaos, as Credit Anstalt's default was transmitted through the rest of the western financial system through a combination of sheer fear as well as the interlocking exposure between major banks.

Since the Great Depression, the global financial system has become significantly more connected, as we saw all too well with the effects of the Lehman collapse. To give the reader a sense of the connections within the eurozone's financial system, the chart below should amply demonstrate the risks with even one major eurozone country such as Spain or Italy going bust:

With that said, while I know that advocating for QE is not a popular position, I believe that most commentators are taking a far too sanguine view of what the affects of a eurozone split would be. In my opinion, it would usher in another Great Depression, centered in Europe, but spreading to the rest of the world in one form or another as well. Just to give a sense of what the economic effects of a eurozone split might be, consider the chart below from Germany's Spiegel.

As you can see, across the eurozone, we would see contractions in the GDP of eurozone countries of at least 10% or more, with unemployment shooting up to unsustainable levels as well. Does anyone think that the social fabric in France can hold together with an 11% drop in GDP and unemployment reaching nearly 16%? Can anyone seriously believe that the U.S. would not fall back into a serious recession as well in the above scenario? Again, I firmly believe that many - if not the majority - of people in both the U.S. and Europe are underestimating how truly catastrophic the end of the euro would be.

How could an investor protect themselves from the effects of a collapse of the euro? I have always argued that a small exposure to Treasury bonds are the best way to hedge an equity portfolio. Were the eurozone to truly implode as discussed above, there would surely be a massive rush into the dollar as investors around the world flee towards what is viewed as the ultimate safe haven. It would not be at all surprising then to see Treasury yields reach rock-bottom levels, with many investors only too happy to accept negative yields in return for safety.

Options include the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF), the iShares Barclays 10-20 Year Treasury Bond Fund (NYSEARCA:TLH), and the iShares Barclays 20+ Year Treasury Bonds (NYSEARCA:TLT). I do of course acknowledge the already record low yields from Treasuries, but consider this trade to be a pure hedge against catastrophe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold some Treasury bonds in my 401(k).