I was worried about the Eurozone in January 2009. And again in December. Maybe it was just my Euroskeptic "Anglo-Saxon" genes talking, but those old posts read quite well today. I mentioned my worries again in January 2010, when I made my New Year's forecast for Canada. "My main worry is that something will go badly wrong in Eurozone financial markets. I find it very hard to predict how that would affect Canadian financial markets."
That's what I want to try to do now: predict how the fallout will affect the rest of the world, including Canada.
The main problem with the Eurozone is that there's a central bank, but no central fiscal authority. To paraphrase Kissinger, "Who do I call, if I want to talk to the Eurozone?". (Or Gertrude Stein "There's no there there"?) They can't coordinate monetary and fiscal policy. The Bank of Canada can buy Canadian Federal government bonds. It can even buy Canadian Provincial government bonds, if it feels it really needs to. The Bank of Canada and the Federal government can decide whether or not to bail out a Canadian bank or province. Ultimately, the Canadian monetary and fiscal authority are spending out of the same pot. They can decide to deal with, or not deal with, a liquidity and/or solvency crisis. There's nobody in the Eurozone that can make that decision. The ECB holds Greek government bonds as colateral when it expands the monetary base. And commercial banks both inside and outside Greece hold those same bonds. Who bails out what if Greece defaults? And what if the liquidity/solvency crisis spreads to other Eurozone countries?
It's difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies.
It's harder still to see how a Eurozone crisis will affect the rest of the world, and Canada.
My own event study, using the time-honoured "eyeball method", suggests that a Eurozone financial crisis will raise the exchange rate of the US dollar against the Euro (obviously), but also (less obviously) raise the US dollar against other non-Euro currencies, like the Loonie. Presumably because the US dollar is, by social convention, the ultimate liquid asset, and the Loonie isn't.
Since Canada does much more trade with the US than with the Eurozone, a Eurozone crisis would probably depreciate the Loonie on a trade-weighted basis. By itself, that would tend to raise Canadian aggregate demand. But the Eurozone is big enough to affect world aggregate demand, and directly or indirectly the demand for Canadian exports, including commodity prices. The net effect could go either way.
Then there's the effect on Canadian financial markets. As far as I know, Canadian financial institutions are not especially exposed to Eurozone assets (anyone know better?). But financial contagion, in a liquidity crisis, seems to follow symbolism as much as fundamentals, as can happen in any case of multiple equilibria. "Canada" doesn't sound much like "Europe"; but who knows.
That's all I can figure out. Anyone got any better ideas?