What Does It Look Like When an Economy Collapses?

Released: 29-Nov-2011 2:45 PM EST
Source Newsroom: University of Iowa
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Newswise — Europe's financial crisis has now reached a point where many economists worry the continent's economy could collapse in weeks, if not days, unless political leaders can agree on a bailout package for economies groaning under unmanageable debt loads.

But what would an economic crash look like when the crash is only metaphorical, so there's no actual rubble or twisted metal strewn about? And how much time would pass before we knew it happened?

"There would be immediate financial chaos," said Paul Weller, a professor of finance at the University of Iowa's Tippie College of Business. "Europe would be plunged into a deep recession and the real economic effects would come into play quite quickly."

Most worst-case scenarios that have been playing out in recent days involve a default by Italy's government on its sovereign debt, a scenario Weller believes is unlikely, but "is more likely than it was a few weeks ago." The country would need billions of Euros from the European Central Bank to relieve its staggering $2.5 trillion debt, but leaders in other Eurozone countries are balking at such a large amount. They want Italy, Greece, and other struggling countries to put more effort into reforming their economies first, and there's political resistance in Germany because the country's still-strong economy would likely bear most of the costs of any bailout.

Weller said the triggering event of an all-out economic collapse would be an announcement that "Italy has begun an orderly debt restructuring, which is really a euphemism for default."

After that, he says the first immediate visible sign that the economy has collapsed would be runs on banks, leading to long lines at banks and ATMs and people spending lots of time online trying to get their money out of failing banks. This would begin on the day of the default in Italy if not earlier, then quickly spread to the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain), other Eurozone countries with massive debt and fragile economies that are also in danger of default. Eventually, he said banks in other parts of Europe, in particular France and Germany, would feel the effects, and then banks in other countries.

With no cash, many banks go out of business and those that survive stop lending. Credit dries up, leaving even healthy businesses with no cash to pay their bills or short-term debt and no choice but to close their doors. Workers are laid off within weeks and unemployment shoots up. A default also likely leads to the break-up of the Eurozone and the collapse of the European Union as an economic entity, leading to more economic and political chaos.

Governments fall and in a matter of months, Europe is in a deep recession with high unemployment and unstable, austerity-wrecked governments unable to provide assistance or stimulus.

Weller says the U.S. economy would take a hit because American banks own huge amounts of European debt and credit default swaps written on that debt. With Europe's economy plunging off a cliff, those banks are forced to swallow a loss on most if not all of that debt.

He says the current European scenario is similar to what happened when the bankrupt investment bank Lehman Bros. collapsed in 2008, causing a credit freeze among other lenders and investment banks that sent the U.S. economy into recession within a quarter. The damage was so sudden and so traumatic that the Federal Reserve immediately took action to minimize the fallout and spent billions of dollars to prop up other weakened financial services companies, while Congress passed the Troubled Asset Relief Program.

Weller said the EU scenario is similar, with Italy in the role of Lehman Bros. and the European Central Bank as the Fed. But he is cautiously optimistic that the collapse that would have occurred in 2008 without Fed intervention won't play out because he thinks Europe's political leaders will eventually agree on a bailout plan for Italy and other beleaguered eurozone economies. It might not happen until the eleventh hour, but Weller said a collapse would be so catastrophic that politicians, especially in Germany, will do all within their power to sell a bailout to voters as a least-bad option.

"When people stare into the abyss, they often decide other options are worth pursuing," he says.


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