Officials from the Bank, the Treasury and the Financial Services Authority are drawing up plans in the expectation that a Greek departure from monetary union – increasingly seen as inevitable by financial markets – could be as damaging to the global economy as the collapse of Lehman Brothers in September 2008.
With a second election in Greece called for on June 17, King dropped a strong hint that the Bank would take fresh steps to stimulate growth if policymakers in Europe failed to deal with the sovereign debt crisis.
"We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country's history, the biggest fiscal deficit in our peacetime history and our biggest trading partner, the euro area, is tearing itself apart without any obvious solution," he said.
Doug McWilliams, of the Center for Economic and Business Research, said a planned break-up of the single currency would cost 2% of euro-zone GDP ($300 billion), but a disorderly collapse would result in a 5% drop in output, a $1 trillion loss. "The end of the euro in its current form is a certainty," he added.
Alistair Darling, who was Chancellor of the Exchequer under the former Labor administration, said: "This has the seeds of something disastrous. It is madness. If it spreads to bigger countries, this could be really disastrous for Europe. It could consign us to years of stagnation."
Capital flight from Greece has increased since it became clear that a coalition government could not be formed after the election earlier this month. The Greek president, Karolos Papoulias, said citizens were withdrawing their money amid "great fear that could develop into panic" at the risk of a debt default and exit from the euro area, according to minutes of their meetings posted on the presidency's website. In little more than a week following the election on May 6, €3 billion was withdrawn from bank accounts. The central bank reported that €800 million was taken out in a single day earlier this week.
The head of the International Institute of Finance banking lobby, Charles Dallara, said money was leaving Greece at a growing pace due to political uncertainty. "There has been a pickup of deposit flight from Greece, but I think that is stabilizable once you get a new government in place, if that government reaffirms its intention to remain in the euro zone." The damage to the rest of Europe if Greece were to leave the euro would be "somewhere between catastrophic and Armageddon", he said.
The Spanish prime minister, Mariano Rajoy, told parliament that his country faced trouble financing itself as borrowing costs shoot up to "astronomic" levels. The Irish finance minister, Michael Noonan, said Dublin's plan to return to capital markets in late 2013 might not be achievable because of the uncertainty.
The first meeting between French president François Hollande and German chancellor Angela Merkel helped to calm nerves in the markets at one stage, with suggestions that Berlin might be amenable to initiatives to boost growth in Greece and the other austerity-stricken nations of the euro zone.
The jittery mood was underlined by a fall in European shares and the single currency late in the day amid reports that the European Central Bank was cutting off its funding lifeline to Greek banks that had failed to amass enough capital to protect them from future losses.
The ECB later said it expected the Greek central bank to use part of the €130 billion bailout from the E.U. and IMF to ensure that the country's banks were safeguarded from collapse, and that they would receive additional help from Frankfurt only once this had happened. Already delayed by the political uncertainty in Greece, €18 billion is now expected to be released to recapitalize the banks.
Sony Kapoor, of the Brussels-based Re-Define thinktank, said: "The high-stakes game of chicken between Greek and other E.U. politicians must end now. Those saying that a Greek exit from the euro zone will not be a big deal either don't know what they are talking about, or have some ulterior motives. The social, political and economic damage to the E.U. from a Greek exit is potentially incalculable."
At the G8 summit, which starts on Friday, President Obama will press Merkel to lean more towards a growth package for Europe, instead of pressing so hard for the austerity measures that were rejected by Greek voters.
Foreign affairs analysts said that Obama's leverage with the European leaders is minimal. Although the U.S. has the economic muscle to help Europe out of its mess, the Obama administration has taken the strategic decision not to become involved directly.
Instead, President Obama is to use the Camp David summit for some quiet diplomacy, hoping to sway Merkel to endorse some immediate actions to help growth.
King, speaking at the publication of the Bank of England's quarterly inflation report, said growth in Britain was weaker and inflation higher than Threadneedle Street had expected three months ago. It would take until 2014 for output to return to where it was in 2008, when Britain's deepest post-war recession began.
"What is so depressing about it is that this is a rerun of the debates in 2007/08 – these are not liquidity problems, they are solvency problems," King said. "Imbalances between countries in the euro area have created creditors and debtors and at some point the credit losses will need to be recognized and absorbed and shared around," he said.
"Until that is done, there will not be a resolution. That is why just kicking the can down the road is not an answer. The European Central Bank has performed heroically in trying to buy time but that time hasn't been used to put in place fundamental underlying solutions."
Intellpuke: You can read this article by Guardian Economics Editor Larry Elliott, City Editor Jill Treanor and Political Editor Patrick Wintour in context here: www.guardian.co.uk/global/2012/may/16/cost-greek-exit-euro-emerges
Note: In the U.K., "City" refers to London's financial district.