


Let me elaborate a little bit. If the balance tilts against the euro zone, investors will shift the composition of their portfolios and deteriorate its credit channel. Whether or not this triggers deflation of euro-zone prices depends on the role of euro‐denominated assets for collateral and in facilitating commercial transactions. Typically, when EMs are faced with an episode of similar characteristics, there is a portfolio shift in favour of foreign‐exchange-denominated assets triggering maxi‐devaluations and inflation. 

However, the euro area is a large currency zone where the euro is well-established as a unit of account, and a central bank which is strongly averse to inflation; therefore, the “flight to quality” may produce opposite effects, namely, strengthening of the euro and price deflation. This will be a kiss of death for the euro-zone real sector because, to the weaker competitive conditions triggered by currency appreciation, price deflation may add two lethal factors: (1) debt deflation (i.e., increase in the real value of the debt not indexed to prices, as was pointed out long ago by Irving Fisher), and (2) the expectation that prices will continue falling. Factor (1) further dries up credit flows, while factor (2) increases the real return of cash balances and, hence, lowers aggregate demand. 

Consequently, the first question that calls for an answer is: who is likely to win the tug‐of‐war? This is not an easy question and I don’t have an easy answer. The EMs are not a trade or currency union. Each country is on its own. “Sudden stops” have shown to be devastating because these economies are not protected by anything resembling developed markets lender of last resort. While EM sudden stops have provoked draconian current account adjustment, satellite euro-zone economies like Italy, Portugal and Spain, for instance, took more than four years to bring their current-account deficits to near zero. However, a serious problem is that the European Central Bank (ECB) seems to be reaching the end of the rope. A major flight‐to‐quality episode would call for further relaxation of ECB credit, which is likely to meet major opposition in its board.  

Moreover, EM banks have been largely free from “toxic assets” and can better fend for themselves than euro-zone banks that so far have survived partly due to the ECB help. Thus, if the ECB falters in coming to their rescue in a new flight‐to‐quality episode, their chances of surviving are bleak compared to EM banks. Moreover, despite their dysfunctionality as a trade or currency union, some key EMs (notably in the Middle East, Africa and Latin America) are resource-rich, and they still have vast expanses of unexploited resources. These areas will benefit from continued growth in China, while for the euro zone it may signify stiffer industrial competition from abroad. This leads me to conclude that the tug‐of‐war is likely to last for some time and the winner will result from some unexpected event (e.g., the rise of an influential populist leader in one of these regions, or a sudden dimming of China’s prospects). The good news is that while the outcome of the tug‐of‐war is unresolved, the impact of a rise in American interest rates is likely to be minor because euro zone‐EM is a large economic area compared to America (about twice its size measured by GDP).  

The second question is: what can the euro zone do if price deflation sets in? In my opinion, there will be few policy options, and none qualifies as a silver bullet. My preferred option is further relaxation of collateral conditions for access to ECB credit lines which, as pointed out above, will be hard to implement. Failing that, open debt default may be unavoidable. This will signify a serious blow to the credibility of capitalism’s rules of the game. It may trigger a worldwide move towards autarky and major government intervention. All of this could somehow be prevented if the G20, for example, finds the energy and imagination that it mustered at the start of the subprime crisis. But it takes an inveterate optimist to believe that this will happen before things get much worse.  

In sum, the euro zone’s recovery is hampered by its own structural weaknesses and by the rising role of emerging markets. A major euro-zone relapse cannot be discounted, and if it happens, the whole world will have to come to the rescue. The consequences of this are very hard to fathom. Thus, the major lesson that I draw from these considerations is that the euro zone should at least become aware that they are still sailing through treacherous waters, and that the last things they need are political/diplomatic fights that reveal severe political dysfunctionality in the euro zone.