“If the euro fails, then Europe fails.”

Angela Merkel’s staunch defence of the single currency, made in the Bundestag this month, is widely shared by other European leaders. The German chancellor’s sentiment demonstrates the political will not to let Europe’s sovereign debt crisis undermine the single currency.

So long as this level of political capital is invested in the euro, monetary union is highly likely to survive. However, the talk among investors and some European politicians this week has been of Greek default. The graphic below outlines the likely consequences of a default by Greece. It is a description, not a prediction – a description that includes the possibility of the break-up of the eurozone, though even in the event of Greek default that outcome is far from inevitable.

Plan A, as far as European authorities are concerned, is to implement the agreement struck on July 21. Under the deal, Greece was offered a second programme of loans, worth €109bn, including the guarantee that Athens would not need to return to financial markets for years, borrowing instead from other European countries and the International Monetary Fund at low interest rates. The private sector would take a writedown of its debt to help ease the burden facing Greece. And the European financial stability facility – the temporary bail-out fund – would become more flexible in order to limit contagion from one eurozone country’s bonds to others.

By 2013, the replacement permanent European stability mechanism should be in place to provide greater economic governance in the eurozone, and as a fund to ensure that countries with difficulties borrowing in the markets had rapid access to loans alongside adjustment programmes until they were again able to roll over their debt in the markets.

That is the plan. But in the meantime, something might give – such is the unpredictability of events in a crisis. In those circumstances, Greece could default. A momentous decision not to service its debts – owed to other European countries, banks and the private sector – would start an alternative, and potentially dangerous, sequence of events.

Because Athens still does not raise sufficient tax revenues to fund its public services, it would fail to pay all of its domestic bills. Public sector workers might not be paid, some social security benefits might fall short. The shock of default and the lack of money would send the economy reeling.

At the same time as the Greek state ran out of money, the country’s banks would face collapse because their holdings of domestic sovereign bonds would be heavily written down. The European Central Bank could not accept defaulted bonds as collateral to lend to banks, since they would be worth little.

The closure, even temporarily, of payment systems and cash machines would amplify the problems. To restart normal economic life, Greece would need to recapitalise its banks and balance its books on a day-to-day basis. If creditors were willing to lend fresh money to Athens, the direct consequences could stop there. But finding new lenders after default is not easy.

The alternative would be to restore Greece’s ability to create money to pay its bills – and that would require exit from the euro, to re-establish the central bank’s ability to create money.

The effects of any default would not be limited to Greece, however, since the investors would then question who was next. In a bid to avoid big losses, euros would flow from countries deemed at risk to those deemed safe. The sums are potentially huge, and the flows would reduce the value of sovereign debt of “at risk” nations. Plunging bond prices would further undermine many European banks and confidence in eurozone economies.

A further slowdown would amplify this contagion. While the ECB has the firepower to fund eurozone banks so long as they are solvent, any economic dislocation caused by contagion could become so severe that other countries would have to to borrow more and on ever more unreasonable terms. More countries could decide to default.

If one country were to leave the euro, the fear would rise that others would follow, creating exchange rate risk across the zone – smart euros would fly out of, say, Tuscany and into Bavaria in case Italy also left the euro. Even so, the ECB could act as a circuit breaker, offering to buy unlimited sovereign bonds of countries under pressure – but that would require agreement across the zone that such purchases were acceptable.

If such unity were lacking – as it has been to date – other countries could find themselves with little option but to follow Greece out of the single currency, which could then break apart.

None of these events is inevitable. But such are the vicious feedback loops in the system that everyone should be aware of the considerable risks. Should Athens default, the risks are real that both the euro and Europe would fail.

Copyright The Financial Times Limited 2018. All rights reserved.

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