Today’s coordinated central banks action is a very positive step to stabilize markets, as it amounts to the shock to expectations needed to break the crisis dynamics that had intensified in the last 2-3 weeks. However, it is the most prominent proof that European crisis management had failed, which fed speculation of a euro break up or disappearance. Even though the break-up of the euro has recently become a possible scenario, it is still a low probability one. But because it is a catastrophic scenario, it requires debate and planning, which is partially responsible for the recent selloff.

European policy makers failed to convince the markets that they understood what it would take to address the current crisis. Though the recent announcements contained the right ideas, magnitudes and details were insufficient. As it became clear the European crisis management failed, politicians started to move towards addressing the underlying fundamental problems of the euro (lack of a fiscal authority that backs the euro), which is a good medium-term effort, but it does not address crisis dynamics, panic, liquidity problems, bank capital shortages, etc. The repeated reluctance by German officials to step up made it necessary for the rest of the world to try to rescue the euro.

Central bank coordination can shock markets, reset expectations, but is not a solution to the problems in Europe, thus it can only last for a few weeks. Now Europeans have to show they get it, and that they are willing to mend the insufficiencies of previous efforts. The most likely scenario is a set of steps towards:  institutional reforms that would give the euro a consolidated fiscal backing (some treaty changes that need to be spelled out, then voted); some countries surrendering fiscal flexibility to the EU (with credible rules and enforcement, to avoid something like the original violations of Maastricht by France and Germany); fiscal and structural reforms (especially in Italy, to minimize the probability of insolvency through slightly higher growth and lower interest costs); and, a credible large liquidity backstop for sovereigns and banks. None of these are easy tasks, and all pose coordination failure and political risks. In sum, huge liquidity support in the short term, growth prospects in the medium-term.

Risk management, as opposed to real incentives or plans by core countries to change the fundamental structure of the euro, justifies the recent debate and analysis of the scenarios in which the euro breaks up. European politicians, at least in core countries (Germany, France, Spain, Italy), are most likely not thinking of how to break the euro but how to save it. Saving it could still mean expelling insolvent (preferably small) countries, but it requires that at least those four countries stay in.  As some have said, a scenario in which a group of small insolvent uncompetitive countries exit the euro would strengthen the euro. But a scenario in which Germany and the like exit the euro would be a severe crisis, not to mention the unthinkable policy and legal challenges that would bring about.

Thinking through the break up scenarios is like trying to forecast the results of a World Cup, game by game a few months in advance. Almost impossible. If poor countries leave, depending on how it is done, each would look like Argentina 2002, but the impact on French and German banks would be clearly different. The question there is where the devaluation happens, in terms of balance sheets. On the other hand, if rich countries (especially Germany) leave, then the euro either depreciates enough that those in it decide to keep the new crappy currency, or it implodes and each country decides to regain independent monetary policy. Both scenarios might have similar effects, since the problem with both is the destruction of value of assets related to the poorer countries in the balance sheet of core countries banks, as well as the disruption in trade and markets the result from the break up. European politicians and bankers have to understand this. Market action and international debate over the last few weeks brought this scenarios to fore, which is why it is now more likely that European politicians move further in the direction started a month ago. This means that we are getting closer to getting a large enough liquidity backstop (a combination of the ECB, IMF, and rich EU countries). Most likely the ECB (and the necessary political support from Germany) was delayed in order not to affect the incentives for reform in Italy et al. But that game has limits, and it seems clear we are close to it. Over the next 2-3 weeks we should get measures and actions that hopefully bring us to an end of this 2-year old painful approximation process.

In sum, the probability of a euro break-up or disappearance had increased from almost nothing to something non-negligible. It is still a low probability event, but requires thought and planning. Today’s central banks action can reset expectations and allow for 2-3 weeks of calm. But Europe needs to provide convincing evidence it is willing to do what it takes. Even if they do, Europe will be in recession, but at least they do not spread the crisis to the rest of the world.