In the 1930s, the American economist Irving Fisher outlined the dangers of debt deflation dynamics. It starts with the distress-selling of assets by borrowers to reduce their debt. Next, banks' balance sheets contract as customers pay off their debt. A general fall in asset prices creates a further fall in business net worth. The consequent decline in profits cuts back trade volume, and households feel less confident to spend and investors worry about the future. At the macro level, trade and output falls while unemployment grows, causing more market pessimism. As people begin to hoard cash, the velocity of circulation slows further. This causes a fall in nominal rates, but since inflation may be falling faster, the rise in real rates worsens the debt burden of the borrowers. The euro zone is in the grip of this depressing state of affairs. Having just returned from Paris, London and Dublin, I heard only doom and gloom; a normally unflappable euro technocrat even accused the media of trying to kill the euro by fanning more fear. The options for saving the euro appear more limited by the day. There is no doubt in my mind that the German proposal of fiscal union is a sensible solution, because it addresses the structural defect of not having a fiscal mechanism to deal with the side effects of a currency union. The markets had a temporary rally, even as the new Italian prime minister announced austerity measures to restore confidence in Italian bonds. The interest rate on 10-year Italian bonds duly fell from 7.3per cent a year to 6per cent, but even at that level, the real interest rate (after deducting inflation of 3.3per cent) is 2.7per cent. With the economy growing at near zero and debt at over 100 per cent of gross domestic product, it's not surprising that the markets feel the Italian debt situation is unsustainable. Thus, while the package agreed by German Chancellor Angela Merkel and French President Nicolas Sarkozy may have staved off disaster for now, financial markets still think they cannot fix a plane in mid-flight. The arithmetic of debt deflation is relentless. High real interest rates deflate asset prices, but bank liabilities in the form of deposits are fixed nominally. So the pressure is on European bank balance sheets. The banks are in a bind because they hold a lot of European sovereign debt paper, which is deflating in value as real interest rates rise. The European problem is a bank-fiscal bind: the governments have to bail out the banks, but their own fiscal debt overhang is the cause of further deflation. The financial consensus seems to insist that the European Central Bank must print money and go for zero interest rates like the US Federal Reserve. The ECB has resisted this because of the German fear of inflation. ECB president Mario Draghi is already preparing the ground for this action by cutting interest rates slightly. The European banking system is going through a liquidity crunch because banks are scared of lending to each other, and there are signs that there is an internal flight to quality, as depositors shift their savings to higher-quality bonds within the euro zone. So the surplus countries like Germany are flush with inflows, whereas illiquidity plagues the deficit countries like Italy. Visiting Dublin for the first time, it was noticeable that there were many commercial properties for sale. My host remarked that his property that was worth Euro1.3million (HK$13.5million) before the crisis is now worth less than Euro500,000 (HK$5.2million). Ireland has certainly undertaken a Hong Kong-style deflation in the wake of the euro zone crisis. Hong Kong's experience with the link to the US dollar meant the economy must be flexible to maintain the fixed exchange rate. Ireland has to do the same. The Irish authorities understand that restoring growth and confidence is the only viable way out of debt deflation. The World Bank ranks Ireland as the 10th easiest place in the world to do business. Unit labour costs have fallen and exports have grown in the past 12 months, bringing the current account into balance. The economy is now back to 1 per cent growth this year, after suffering negative growth since 2007. Thus, Ireland is best poised for growth in the event the ECB goes for quantitative easing and if the euro depreciates. The euro zone crisis must be seen in its proper context. The euro zone is not a poor economic bloc. A survey of household debt showed that the Italians have the lowest household debt relative to the other euro zone households. This means the Italian people are rich, while the government may be in hock. Hence, it is well within the means of the undertaxed Italian people to solve their government's fiscal problems. This is not a question of using the savings of poorer Asians to rescue richer Europeans. Before the crisis, the markets underpriced European sovereign debt risks. Now, they demand usurious real interest rates that can only mean eventual default, which would also destroy the value of their investments. Companies can go bankrupt, but countries do not disappear. The political reality is that the state cannot afford to satisfy its relatively few creditors by destroying the jobs and security of its many citizens. The real issue is whether, ultimately, the power of the market wins over the will of the state. In August 1998, the Hong Kong government had to intervene in the markets to restore stability. This battle is being fought in Europe today. Whichever side wins, the outcome is likely to be ugly. Andrew Sheng is president of the Fung Global Institute
