Fiddling While Rome Burns (or, Where is the Cavalry?)

While European leaders have been fiddling over how to leverage the EFSF rescue fund to prevent contagion to Italian and Spanish debt, Italy has already entered its death spiral, with interest rates on its sovereign debt breaching the 7% mark today. The vague prospect of finally terminating reruns of the Burlesqueconi show has not been enough to reassure markets. Quite the contrary.

Italy is only as solvent as financial markets think it is; its underlying fundamentals during the crisis were not bad at all, in contrast to Greece. In a word, we are confronted with a self-fulfilling prophecy, a crisis of confidence, a bank run. At a high enough rate of interest any country becomes insolvent, even Germany.

But there is a classical solution to this financial unraveling (thanks to Walter Bagehot): the lender of last resort (aka the central bank). In this case, the ECB, which has infinite resources (it can print Euros), political independence (in principle), and can act immediately without the unanimous approval of 17 or 27 squabbling Eurozone/EU governments. A credible, unconditional and unlimited commitment to buy up all the Italian bonds necessary to stabilize the interest rate would put an immediate stop to the run on Italian debt, probably without having to spend much money at all. It's been done before. The Swiss central bank has been holding the line quite well on the appreciation of the franc (a similar but not identical problem). There's no run on the equally indebted sovereigns behind the Pound, Dollar or Yen. So why isn't the ECB riding to the rescue like the cavalry in an old fashioned John Wayne Western?

1. The ECB is chartered to fight inflation, not finance government debt and defend the Euro. The trauma of the German hyperinflation of 1923, when the Reichsbank monetarized the government deficit, still haunts German economists. Two prominent German ECB directors have already resigned on this issue - Axel Weber (who was in line to become ECB president) and chief economist Jürgen Stark. Neither specified what alternative there was to protect the Euro from unraveling except austerity, austerity, austerity, and we now see where that has gotten us. Strangely, the even greater trauma of Brüning's 1931 austerity policy does not seem to haunt German economists.
   
2. The new ECB president Mario Draghi may think he needs the bargaining chip of Italian insolvency to force the Italian government and parliament to pass the structural reforms (to pensions and labor markets) his predecessor Trichet made a prerequisite for ECB market intervention. He's probably right, but Italy may be bond-vigilante roadkill before that happens. Moreover, these reforms would not have any immediate effect on Italy's growth prospects anyway. It's Italy's nonexistent productivity growth that has been holding it back.
   
3. Draghi, as an Italian (although an Italian central bank president who stood up to his own government at the time), still needs to establish his bona fides as ECB president. He can't be seen, particularly to a German audience, as rushing to the defense of his own 'dissolute' country.

So it now looks like the sack of the Euro will happen in Rome rather than in Athens. Well, either way it will be a tragedy within the great European classical tradition. The sack of Rome in 455 ushered in five centuries of darkness. Let's hope that the canceling of the Burlesqueconi show is somewhat less traumatic. (As long as they continue The Simpsons we might just get through those five centuries.)

Coming attractions on this channel: Why Germany is ultimately to blame for the Eurozone crisis (a reality program for statistics nerds and economic moralists)