A woman threatens to jump after her employer, the Labour Housing Organisation in Athens, was labelled for closure. Photograph: Alkis Konstantinidis/EPA
Central banks across Europe have a collective nightmare. It is of the dayGreece defaults on its debts, and the Aegean Sea is awash with small boats in which fleeing Greeks huddle with suitcases full of euros. Guards patrol the border in an attempt to prevent the flight of capital. Things get ugly and there are shootings, captured on film. Despite the best efforts of policymakers in Athens, Brussels and Frankfurt, it proves impossible to contain the panic, which spreads to Portugal and Ireland, the other two countries going through tough austerity programmes in return for bailouts from the EU and the IMF.
Across Europe, governments are engaged in contingency planning for this sort of scenario. In the UK – which had first-hand experience of how crises can escalate when there was a three-day run on Northern Rock in 2007 – the Bank of England, the Treasury and the Financial Services Authority have been "war-gaming" what might be expected in the event of Greece repudiating its debts and leaving the single currency.
Most big businesses across the UK have also made preparations for aeuro meltdown, fearful not just of the direct impact on sales but of a drying up of credit and trade finance. Few doubt that a messy Greek default would lead to a credit crunch at least equal in severity to that which followed the collapse of Lehman Brothers in September 2008.
Sir Mervyn King, the governor of the Bank of England, said it was impossible for any government to be fully prepared, but said the UK authorities were braced for a range of outcomes. Threadneedle Street is convinced that failure to end Europe's long-running debt crisis would have severe implications for the UK economy. King said there would be a substantial fall in spending, exports would collapse and hopes of rebalancing the economy would be dashed.
Policymakers have stepped up the pace of their planning in recent days following the marked deterioration in the relationship between Greece and its single-currency partners. Athens believes that the rest of the eurozone wants Greece out, while Germany is leading the group of hardline countries demanding assurances before the €130bn bailout is agreed.
While Germany's finance minister, Wolfgang Schäuble, says "we're better prepared than two years ago", others believe the ramifications of a Greek exit would be felt globally. "The consequences would be devastating for Greek citizens and particularly for the most vulnerable," predicted Amadeu Altafaj, spokesman for Europe's commissioner for economic and monetary affairs, Olli Rehn. "Consequences would be felt throughout the eurozone and beyond."
European policymakers are looking beyond contingency planning for a Greek default to the possibility of the country crashing out of the euro. Greece would probably have to impose capital controls – limits on the amount of money that can be taken in and out of the country – while it implemented "drachmatisation". All balances at Greek banks would probably be redenominated at a fixed exchange rate with the new (or rather the old) currency; but banks could be shut, or strict limits placed on withdrawals from cash machines, while the details were worked out.
These capital controls, and the difficulty of getting hold of cash inside Greece, would have knock-on effects for any businesses, holidaymakers or ex-pats in the country at the time.
In the UK, Whitehall insiders said the various government departments that would have to be involved have been discussing how to minimise the impact for months. The Foreign Office would have to think about how to bring home Britons trapped in Greece without enough funds to get out; Vince Cable's Department for Business, Innovation and Skills would have to offer advice, and possibly funding, to businesses with exposure to the country; and the Treasury would also have a key role.
The other direct impact would be on the financial sector – for any banks still holding Greek bonds, for example. In the UK, the much-derided "tripartite committee" – the Bank of England, the Treasury, and City regulator the Financial Services Authority – would still be the locus for decision-making. As part of the government's new arrangements for coping with financial crises, the new Financial Policy Committee, chaired by King, would also meet to decide what action was necessary.
In the worst-case scenario, Greece could be followed by more countries as the markets speculated on whether Portugal, Ireland or Spain would be the next to default. If the bonds of all these countries were called into question, Britain's banks could be hit hard, and the Treasury could even be forced to contemplate fresh taxpayer-backed nationalisations.
It is to forestall a Greek domino effect that the European Central Bank has flooded Europe's banks with cheap money over the past two months, easing funding concerns and bringing down interest rates on Spanish and Italian bonds. Brussels believes the replacement of Silvio Berlusconi as Italian prime minister by Mario Monti has helped to create a firewall between Greece and its southern European neighbours. The containment strategy has worked up until now, but may be about to face its biggest test.
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