The Larger Issue in the Eurozone is Historically Weak Economic Conditions in Italy and Spain
While the situation in Cyprus has dominated the headlines for the past few weeks, what looks to us as a more significant risk to the Eurozone is the potentially destabilizing pressures that will come from the chronic and severe weakness of the Spanish and Italian economies. The steps taken so far by the ECB have been enough to create stabilization of the peripheral financing markets, but those steps have been insufficient to offset the acute deflationary deleveraging forces in these economies. At this point, economic output relative to potential GDP, unemployment, and production readings in both countries are at their worst levels in 50 years, and growth continues to be well below potential. Given current fiscal and monetary policy plans in place, it doesn't appear that conditions will meaningfully improve in the near future. As we'll describe below, there are few historical precedents for countries having endured this level of economic pain for very long without there being a significant change in policy (or conflict resolution). So the current economic depression in the periphery is unlikely to persist for long without some form of change of conditions, even if it's not clear what will be done to improve domestic conditions (i.e., further defaults, more transfers from the north, increased monetization). And while it remains an outside risk, the consequences of the pronounced and sustained decline in economic output could produce further political and social instability, which is the real long-term threat to the Eurosystem.