Ah, the Eurozone, one minute you think the crisis is on the brink of resolution and the next a referendum has been called, stock prices have plummeted and the musical hopes of the Italian premier have been dashed.
Although the fact that the UK is not a member of the Eurozone has limited the extent to which we've been affected by the immediate impact of the sovereign debt crises, we are by no means immune. There are three key reasons what what happens in the Eurozone matters.
Firstly, what happens in Europe matters because Europe is our biggest export market. Given weak domestic demand, UK growth is dependent on export growth, which is being held back by ongoing weaknesses in the Euro area.
Europe buys around half of UK exportsValue of goods exports (2004 £m)
Secondly, what happens in Europe matters because of systemic risk
Back in May, Mervyn King gave evidence to the Treasury Select Committee, he said that crisis in Europe could lead to concerns about UK banks.
If, as their crisis evolves and develops, financial markets came to the view that these problems had not been tackled, there was no long-run plan for dealing with the need to regain competitiveness in these other countries, then of course the crisis could not only spread, but it would lead people to speculate, "Well, okay, here is a UK bank, which we are told has rather little exposure to Greece and we can see that, but we don't necessarily know all the exposures of the French and German banks to which the UK banks are themselves exposed". So trying to work out these other links is very hard to judge.
Finally, what happens in Europe matters, because no-one really knows how bad the outcome a disorderly default would look.
The crisis in Europe has knocked the confidence of households and investors around the world. If things were to escalate in Europe it is unclear what the impact of this would be. In the same Treasury Select Committee meeting King argued that:
Even knowing the mechanical links—a matrix of interconnections between banks—does not guarantee that there can't be a sudden loss of confidence in which those who fund banks decide to step back and say, "Look, we have no idea which European bank is exposed really to which other European bank, therefore we will just stop funding European banks". I think US banks and other national banks could be drawn in in those circumstances.
At the time King did not think this was the most likely scenario, but he also added "There is no alternative ultimately for dealing with the fundamental problems." Here's hoping Greece – and the rest of Europe – can deal with these.