UK Treasury prepares for 'economic armageddon' if euro falls apart

UK Treasury prepares for 'economic armageddon' if euro falls apart
This article was published on guardian.co.uk at 16.06 EST on Thursday 10

November 2011. A version appeared on p1 of the Main section section of the Guardian on Thursday 10 November 2011. It was last modified at 20.14 EST on Thursday 10 November 2011.

A trader looks at computer screens at Madrid's bourse
A trader looks at computer screens at Madrid's bourse. The UK is making contingency plans in case the euro falls apart. Photograph: Susana Vera/Reuters

The Treasury and Bank of England are making contingency plans for an "economic Armageddon" if the euro falls apart, business secretary Vince Cable said on Thursday as the European commission slashed its growth forecasts and predicted that the continent could be plunged back into recession next year.

With David Cameron warning that the moment of truth was approaching for the eurozone, ministers are resigned to a severe downgrade of UK growth and public finances when the Office for Budget Responsibility reports this month. Brussels officials said the outlook for the UK economy had deteriorated significantly throughout 2011 and its recovery was lagging rivals'.

The commission now expects the UK economy to expand just 0.7% this year, compared with a forecast of 1.7% in May. Growth for next year is forecast to be just 0.6%, a huge drop on the OBR spring forecast of 2.5 %. An increasingly impatient Cameron again urged the Germans to allow the European Central Bank (ECB) to "act now" and become lender of the last resort to save distressed euro-economies, seen by Britain as the only way to keep the euro from collapse and prevent a wider banking liquidity crisis.

His call came as fears rose that France could be next to be engulfed by the crisis. Brussels downgraded its forecasts for the eurozone's second biggest economy, prompting a sharp rise in benchmark bond yields in France to 3.48% – almost double what Germany pays to borrow money.

Pressure on Italy, where bond yields this week breached the 7% danger level, eased after it appeared that former EU commissioner Mario Monti would be installed as prime minister by the weekend, while in Greece his fellow technocrat Lucas Papademos emerged as the leader of the country's new coalition government after four days of talks.

However, British ministers reported that France was keeping pressure on the ECB day and night to override treaty regulations and take a more interventionist approach, creating a solution to the crisis before it spreads further. Nick Clegg has been pressing the Germans to expand the ECB's role for as long as three months.

Faced by the impasse, Cable admitted Britain was preparing for "all eventualities" in the eurozone, including the breakup of the single currency. "There's a lot of scenario planning in government, thinking about all possible outcomes, and the Treasury is doing that. It affects our trade and potentially, in this Armageddon narrative, it affects the banking system, but we're not there yet," he said.

The contingency planning covers the Financial Services Authority, the Bank of England and the Treasury. It is being led by Tom Scholar, the second Treasury permanent secretary, and is looking at emergency measures to keep the banking system going.

Cameron said on Thursday in a speech on UK growth said that the ECB should now act as the lender of last resort. "Italy is the third largest country in the eurozone," he said. "Its current state is a clear and present danger to the eurozone and the moment of truth is approaching. If the leaders of the eurozone want to save their currency then they, together with the institutions of the eurozone, must act now. The longer the delay, the greater the danger."

Britain is growing increasingly impatient with Berlin for blocking a French plan for the ECB to guarantee the eurozone bailout scheme, the European financial stability facility (EFSF). Separately, Germany shot down the idea discussed at the G20 meeting in Cannes that European countries could use their special drawing rights at the IMF to leverage the EFSF.

Berlin believes it would be wrong for the central bank to act as a lender of last resort because that would jeopardise its independence and fuel inflation.

Senior ECB members insisted they could do little more to intervene, arguing it was up to national governments. The Dutch central bank president, Klaas Knot, a member of the ECB's 23-member policymaking governing council, led the ECB resistance. "We have gone pretty far in what we can do but there is not much more that can be expected from us," Knot told the Dutch parliament. "It is now up to the governments … to make sure the doubts about sustainability, about repayment of individual government debt, are removed as quickly as possible."

A Bundesbank spokesman said there had been no ECB crisis meeting on Wednesday or Thursday. Angela Merkel, the German chancellor, was forced to deny reports that she was planning for the breakup of the euro area, insisting she was focused entirely on maintaining the euro in its current form.

Far from succumbing to the pressure, Merkel's Christian Democratic Union's (CDU) congress in Leipzig next week will demand changes to the ECB that would give euro member states voting rights weighted according to the size of the economy – meaning Germany would have most influence.

The Labour leader, Ed Miliband, a supporter of a more interventionist ECB, called for an emergency EU leaders' summit this weekend, arguing the meeting should not end until an agreement is reached.

But the prime minister's spokesman said it was not more meetings that were needed, but more action.

The scale of the commission's growth forecast downgrade for the euro area, Britain's single largest export market, shocked observers.

But Olli Rehn, EU economic and monetary affairs commissioner, said even this forecast might be over-optimistic, adding that several EU countries would see their economies contract, and overall stagnation would last well into 2012.

Rehn told journalists: "This forecast is in fact the last wake-up call. The recovery in the EU has come to a standstill and there is a risk of a new recession."