Today, members of Europe’s periphery are faced with the inverse of Pascal’s wager. The potential devastation wreaked by the break-up of the currency union is so great that it makes sense to take precautionary actions however unlikely that outcome may be. Unfortunately, the protective measures that Spaniards and others are taking have dire economic consequences. As a result, they raise the probability of a worst-case outcome.
The problems facing Europe’s periphery are similar to a number of emerging market debt crises over the past two centuries, according to Michael Pettis, the author of The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (OUP, 2001).
The typical emerging market boom starts with some development that improves a country’s economic prospects. Capital starts to flow from the global financial centres towards the newly emerging star. Foreign capital fuels prosperity. Prosperity breeds confidence. Believing that currency risk has dissipated, people are tempted by the lower rates available on foreign currency loans.