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Would the Euro Survive the Exit of Both Greece & Catalonia?

Investors seem to be drawing a rather dubious conclusion from this weekend's Catalan elections. The consensus view today is that a vote on independence is now a more distant prospect. This is not necessarily the case. The Catalan President's increased dependence on separatist parties may well bring the issue to a head much sooner than many think. Perhaps as early as next autumn.

There's nothing especially new about the present dispute between Catalonia and Spain's national political leadership. Arguably most of the key arguments date back at least to the 1970s and the end of the Franco era. What is new is the decision of the previously moderate Convergencia I Unió coalition to openly advocate the creation of a new Catalan state.

President Artur Mas took a big gamble in calling these elections, and arguably he took the gamble and lost, since support for his party fell back considerably. Yet from the point of view of finding an orderly resolution to the underlying issue the result is surely not good news. Many external observers were expecting some sort of substantial offer from Spain's Prime Minister Mariano Rajoy after the expected CiU victory, but now, given that President Mas is being seen as the big loser such an offer may not materialize. Indeed Mr Rajoy is not exactly well known for biting bullets and taking difficult decisions rapidly.

But would Spain's Prime Minister be right in thinking he can now relax? It is hard to see how this reading makes any sense. If the Catalan President didn't get a majority, this was not because people were voting not to go down the independence road. The party which came second in the election, the Republican Left party ERC is openly separatist and the far left separatist CUP entered the parliament for the first time with 3 seats.

The key issue now to consider is the governability of Catalonia. The region recently requested a 5 billion Euro bailout from Madrid, via the recently created liquidity fund. The regulations governing access to the fund are quite strict, and give the central government powers to carry out monthly monitoring of regional spending, measures in a way not dissimilar to the current Troika country programs, and indeed to even activate a direct intervention in a region which refuses to cooperate. Representatives of the governing PP party have already referred to the powers contained in Article 153 of the Spanish constitution, which allow a regional government to be suspended and direct rule from Madrid to be implemented. Obviously were this threat to be activated a head on collision would become inevitable.

The most likely outcome now is that Mr Mas will have to reach an agreement with the ERC leader Oriol Junqueras. The outline of such an agreement is not hard to discern, ERC will vote for the 2013 budget in return for a date for the independence consultation, which could now possibly be in the autumn of next year. Delaying longer would only add to the instability.

Naturally, as many analysts have pointed out, the planned vote may be declared illegal by the Spanish government, in which case Artur Mas has already alluded to his strategy. He would not seek to flout the law, but would call another set of elections with a single issue, for or against independence. These elections would constitute a plebiscite, leaving the parliament to then take the final decisions.

Naturally, all of this would sound like cloud cuckoo land were the backdrop not a Euro area in deep crisis, and a Spanish economy which is sinking deeper into the mire.

On the other hand, and just to complicate matters, Greece's debt is evidently on an unsustainable path however you look at it. This week some sort of "band-aid" solution will surely be put together. But getting through to 120 percent in 2020 isn't enough, since the following decade is going to be very challenging demographically for the struggling country, and the economic forecasts for GDP in the interim are hardly realistic. Greece needs either a much more substantial reduction in its debt levels, or a negotiated exit from the euro.

Realists are now pushing this view, but realists are also pragmatic people. They recognize that Angela Merkel has elections looming in the autumn of 2013, and that she can only go so far. So the IMF simply seem to be pushing the idea that it is the principle of accepting more debt pardoning that needs to be established now.

After the German elections are over, the fuller implications of this signal can be fleshed out. By that point Greece's crisis weary population will be ready for neither another year of substantial austerity cuts, nor for yet another year of recession, so a solution will need to be found. If the debt pardoning cannot be great enough then "Grexit" will be on the table as a contemplatable solution.

Which brings us to the world of the investor, and how the Catalan and Greek issues could affect the market for periphery government debt in the future, or indeed the trajectory of conversion risk in the euro area. Most observers are agreed that an independent Catalonia would be out of the EU and out of the Euro. But have they thought about the implications of this conclusion? Without Catalonia, for example, how on earth would the Spanish State ever be able to meet its obligations on the growing mountain of state debt?

Secondly if Catalonia was out of the EU, it would logically also be out of the euro, and the Catalan financial sector without access to euro-system liquidity. But the Catalan financial sector, like the rest of the financial sector in Spain is surviving on life support from the ECB (something like 75 billion euros worth in Catalonia alone), so unless you want systemic institutions collapsing in Europe…

The biggest risk here is that both the Catalan and the Greek issues could come to a head just after the German elections, and the combined effect would be a very strong challenge to Euro continuity. So today as leaders in Madrid, Berlin and Brussels contemplate how to react to the latest vote in Barcelona perhaps they would do well to bear in mind the words of American singer Janice Joplin, "freedom is just another word for having nothing left to lose".

Edward Hugh is a macro economist, who specializes in growth and productivity theory, demographic processes and their impact on macro performance, and the underlying dynamics of migration flows.

He is based in Barcelona, and is currently engaged in research on aging, longevity, fertility and migration, and the impact of all of these on economic growth. Since September 2011 Hugh has been a board member at the Spanish bank Catalunya Caixa