Hugo Dixon

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can’t they see that all that’s needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a Plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone’s fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven’t been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany’s Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won’t rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country’s debts below the promised level of 60 percent of GDP.

What’s more, there’s no guarantee that the current treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result — say by having new treaties signed by a smaller group of countries.

Given all this, pressing ahead with Plan A might suggest that the decision makers in Frankfurt and Berlin are indeed stupid. That would be true if they were sure it would work. But they don’t seem to be. Indeed, the German finance minister called for extra resources for the International Monetary Fund on Friday in seeming recognition that the EFSF on its own won’t be enough to bail out big euro zone countries. Nevertheless, the policymakers in Frankfurt and Berlin still think that everything in Plan A is still necessary or at least desirable, even if it proves insufficient to solve the crisis. It is, for example, really important to keep the pressure on the new Italian and Spanish governments so that they deliver on their potential.

What’s more, coming up with a Plan B is problematic given that the ECB is forbidden from directly funding governments. This doesn’t mean that there’s no way saving the euro if Plan A fails. There are, after all, various gimmicks that could be used to get round the prohibition on directly funding governments. One is for the ECB to lend to the EFSF, making its fire extinguisher fully functional. Another is for the central bank to lend to the IMF and let it then lend to Italy and Spain.

The problem is that either manoeuvre would be extremely controversial as well as possibly open to legal challenge. That’s not to say the ECB would never contemplate unusual measures if that was the only way of preventing the euro breaking apart. But it would seem that, even then, it would only do so if it had political cover.

Such cover is gradually coming. Following the scares of the past week, both Finland and the Netherlands — which, along with Germany, have been the strongest advocates of austerity — started to crack. The Finnish finance minister said that if there were no other alternatives, an increased role for the ECB had to be considered. Similarly, her Dutch counterpart said he’d prefer the EFSF to be strengthened but, if that didn’t work, other measures would have to be considered: “In a crisis, one should never exclude anything beforehand”.

Meanwhile, the ECB seems likely to offer some short-term palliatives. First, it is continuing with its programme of buying sovereign bonds in the secondary market as a way of preventing Italian and Spanish yields going through the roof — a programme that Berlin has studiously avoided criticising. Second, the central bank looks likely to offer longer-term money to banks as well as accepting more types of collateral in return for it — measures that should counteract to some extent a looming credit crunch.  Finally, it may cut interest rates again in December to reduce the deflationary potential of the coming recession.

Fingers crossed, such short-term palliatives will prevent an explosion until Germany implements Plan A and figures out that it isn’t working. But even in the best case, such an approach probably won’t be enough to prevent a nasty recession. Meanwhile, there’s the ever-present risk that a panic could trigger a chain reaction which even a Plan B would be unable to contain.

When confidence in a regime’s permanence is shaken, it can collapse rapidly. The fear or hope of change alters people’s behavior in ways which make that change more likely. This applies to both political regimes such as Hosni Mubarak’s Egypt and economic regimes such as the euro.

Fear that the single currency may break up now risks becoming a self-fulfilling prophecy. Banks and investors are beginning to act as if the single currency might fall apart. Politicians and the European Central Bank need to restore belief that the single currency is here to stay. Otherwise, it could unravel pretty fast.

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view. Since the euro summit on Oct. 26-27, it has become a mainstream scenario. So much so that last week risk premiums on the bonds of even triple-A rated countries such as France and Austria rose to record levels, while Spain became the latest country to be sucked into the danger zone.

The summit itself made two technical decisions which have had damaging, unintended consequences. First, banks underwent a stress test that marked their sovereign bond exposures to market whereas previously regulators maintained the fiction that these positions were risk-free. This meant that lenders suddenly had to start holding capital to back their sovereign debt investments. Not surprisingly, they have become more reluctant to buy bonds. This, in turn, has made it harder for governments to fund themselves.

Second, the summit decided to strong-arm the banks into agreeing to a “voluntary” debt restructuring for Greece. Because the deal is supposedly voluntary, credit default swaps (CDS) – a type of insurance policy that pays out if an entity goes bust – won’t be triggered. This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.

After the summit, things went from bad to worse with Greece’s disastrous plan to call a referendum on its latest bailout plan. That idea was withdrawn – but not before Germany and France suggested that Athens might need to be kicked out of the euro unless it came to heel. The snag is that it would be very hard to isolate the Greeks. If one country could leave the single currency, why not two, three or all 17?

As investors thought about the possibility of a euro break-up, they started factoring in currency risk. Under such a scenario, the new Greek drachma would plummet in value; the new Italian lira and Spanish peseta would also take a tumble; even the new French franc would depreciate versus a vibrant new Deutsche Mark. That gave the market another reason to sell pretty much every non-German government bond – again making it harder for those states to fund themselves.

As if this wasn’t bad enough, banks are also suffering from a liquidity squeeze. It’s not just investors who are getting jittery about putting their money in banks; lenders are reluctant to lend to each other because they are not totally sure that their peers will survive.

Banks outside the euro zone are also cutting their lines of credit to those inside the zone. The big four UK banks cut interbank loans by around a quarter in the three months to end September, according to data compiled by the Financial Times. Meanwhile, the United States is about to embark on a new stress tests of its lenders. This will include contingency planning against further disruptions in Europe. It wouldn’t be surprising if this provoked American banks to cut their exposure to their euro counterparts, further exacerbating their funding problems.

These vicious spirals have drowned out the good news on the political front. Italy, Greece and now Spain have new prime ministers, all of whom seem intent on cutting debts and making their economies fitter. But they will struggle to reduce their borrowing costs unless investors can be convinced that the euro is here to stay.

The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies. But the central bank itself and Germany, the euro zone’s main paymaster, have so far resisted this. In part, this is because they think governments won’t have a strong incentive to reform if they are bailed out too easily.

The logic of making countries sweat so that they address problems they have shirked for years, and sometimes decades, is a good one. But the ECB and Germany should remember that carrots are useful incentives, as well as sticks – and, if they don’t provide the carrot soon, the euro may not survive.

The Super Mario Brothers need to work together to save Italy and the euro.

Even if Mario Monti can form a strong government in Italy, the euro zone is vulnerable to bank runs and a deflationary spiral. Stopping that is the role of Mario Draghi, the European Central Bank’s boss. The zone needs vigorous supply-side reform but looser monetary policy. With Silvo Berlusconi gone, the duo and Germany’s Angela Merkel should try to forge a new grand bargain based on this.

Last week witnessed both the Italians and the Greeks dragged to the brink, look into the abyss and dislike what they saw. The two countries have or are in the process of forming national unity governments led by technocrats. This is a step in the right direction. But dangers abound.

The biggest risk is of a visible bank run. There has already been massive deposit flight in Greece as savers fear that the country could get kicked out of the euro – a scenario which is still real despite Lucas Papademos’ appointment as prime minister. But so far there have been no queues outside branches as there were with the UK’s Northern Rock in 2007. If that were to happen, television pictures would be relayed across Europe in seconds potentially provoking copycat runs.

Even without visible deposit runs, euro zone banks are debilitated. Many have already suffered runs in the wholesale markets: U.S. money market funds have sharply cut supplies of short-term cash; and hardly any bank has been able to issue unsecured bonds since the summer. The banks are able to get money from the ECB but only for up to a year. Their funding problems now look set to suffocate industry via a renewed credit crunch.

Meanwhile, the banks’ difficulties are exacerbating governments’ funding problems. France’s BNP revealed this month that it had cut its holdings of Italian debt by over 40 percent in the previous four months. Other banks could follow suit, thinking it is better to take smallish losses now rather than get caught in a Greek-style debt restructuring later. This means that, even if Monti gets a mandate to push through structural reforms–which need to be more radical than those planned by Berlusconi–Rome could struggle to finance itself on decent terms. Ten-year bond yields, which ended last week at 6.5 percent after shooting up to 7.6 percent, need to come down to 5 percent for the country’s debt to be sustainable.

The euro zone may already be in a double-dip recession. A renewed credit crunch plus extra austerity demanded of governments – France was the latest to tighten its belt last week – could push it into a fairly deep one. The snag is that the more governments raise taxes, the faster economies shrink, which in turn makes it harder for them to balance their books and so piles further pain on the economies.

Many European nations lived beyond their means for years. They enjoyed excessively generous welfare states and didn’t allow the free market to operate properly. So big changes are needed. But the current policy mix isn’t working. A new treatment is required that puts more emphasis on the long-term reforms — such as pushing up pension ages, making it easier to hire and fire, reforming bloated civil services and privatization – and less on short-term pain.

Such a new policy mix would require action not just by governments but by the ECB. The central bank is now the only realistic source of mega funding after many non-euro countries made clear at the G20 summit in Cannes this month that they thought the zone should solve its own problems. China, meanwhile, indicated that it would only help in return for unpalatable quid pro quos such as extra power at the International Monetary Fund.

Draghi and his colleagues at the orthodox central bank need to make three radical changes. Germany, the euro zone’s conservative main paymaster, would need to back the changes to give them political cover.

First, the ECB should offer banks longer-term cash to prevent an imminent credit crunch. Governments should simultaneously require their banks to hold more capital so that they have adequate cushions to withstand the hard times ahead. The 106 billion euros of capital injections agreed at last month’s euro summit should be doubled in line with what the IMF recommended. That might then reassure the ECB that it wasn’t lending to potentially insolvent banks.

Second, the central bank should be prepared to act as a lender of last resort to governments which are following responsible policies. The Lisbon Treaty prevents it from lending directly to states, but that shouldn’t stop it leveraging up the European Financial Stability Facility, the euro zone’s bailout fund. The EFSF would then have the firepower to help Italy and Spain if needed. So long as Berlusconi was presiding over a dysfunctional government, it was sensible to avoid bailing it out. But provided Monti can deliver, that would no longer be relevant.

Finally, the ECB should prepare to launch “quantitative easing.” At the moment, inflation in euro land in 3 percent. But it is soon likely to head below the 2 percent level that the ECB defines as price stability. Given that official interest rates are now 1.25 percent, there’s not much scope for further rate cuts. But the ECB could print money to buy government bonds and other assets, in the same way that the U.S. Federal Reserve and the Bank of England are doing.

The ECB does have a government bond buying operation already. But this is a long way from quantitative easing. First, it is small: 0.8 percent of GDP; the U.S. and UK programs are 16 percent and 18 percent of GDP respectively. Second, the ECB mops up all the money it creates when it buys bonds whereas the Fed and the Bank of England inject extra cash into the economy. The main benefit of a similar operation would be to help restore the competitiveness of struggling economies by weakening the euro which, despite the crisis, is astonishingly strong at $1.38.

Such a grand bargain might sound rational. But is it possible to orchestrate a deal between 17 different countries and a fiercely independent central bank? Not yet. But just as pressure from the markets and Italy’s euro partners has pushed Rome into doing things it wouldn’t have contemplated even weeks ago, pressure from the markets and the rest of the world may soon push the euro zone to be more creative too. The Super Mario Brothers need to get cracking.

PHOTO: Newly appointed Prime Minister Mario Monti looks on following a talk with Italian President Giorgio Napolitano at the Quirinale palace in Rome November 13, 2011. REUTERS/Stefano Rellandini

Chaos, drama and crisis are all Greek words. So is catharsis. Europe is perched between chaos and catharsis, as the political dramas in Athens and Rome reach crisis point. One path leads to destruction; the other rebirth. Though there are signs of hope, a few more missteps will lead down into the chasm.

The dramas in the two cradles of European civilization are similar and, in bizarre ways, linked. Last week’s decision by George Papandreou to call a referendum on whether the Greeks were in favor of the country’s latest bailout program set off a chain reaction that is bringing down not only his government but probably that of Silvio Berlusconi too.

The mad referendum plan, which has now been rescinded, shocked Germany’s Angela Merkel and France’s Nicolas Sarkozy so much that they threatened to cut off funding to Greece unless it got its act together — a move that would drive it out of the euro. But this is probably an empty threat, at least in the short term, because of the way that Athens is roped to Rome. If Greece is pushed over the edge, Italy could be dragged over too and then the whole single currency would collapse. So, ironically, Athens is being saved from the immediate consequences of its delinquency by the fear of a much bigger disaster across the Ionian Sea.

Italian bond yields, which were already uncomfortably high, shot up after the Greek referendum fiasco. Berlusconi was forced to pacify Merkel and Sarkozy at the G20 meeting in Cannes by agreeing to a parliamentary confidence vote on his government’s lackluster reform program as well as to monitoring by the International Monetary Fund. The humiliation in Cannes, where Berlusconi’s finance minister pointedly failed to back him, could be the final nail in the PM’s coffin.

The end of the Berlusconi and Papandreou eras should, in theory, be a cause for celebration. Although the Italian PM’s behavior has been scandalous, whereas the Greek PM’s has not been, they have both led their countries deeper into debt. They are also both members of political castes that have enfeebled their nations for many years. Getting rid of them could be the start of a renewal process.

The snag is that it’s not certain that what comes next will be better. In both countries, where I have spent much of the last fortnight, the best outcome would be national unity governments committed to rooting out corruption and cutting back overgenerous welfare states. This could happen either before or after snap elections. Unfortunately, the old political castes die hard. They could continue bickering over who suffers the most pain and who gets the top jobs until they are staring into the abyss — or even fall in.

Many in the rest of Europe, meanwhile, would probably love to push them over the edge if they were themselves strong enough to take the strain. But Merkel, Sarkozy et al have been criminal in their lack of preparation. The so-called comprehensive plan agreed to at the euro summit of Oct. 26 was another case of too little, too late. Not only was the plan for recapitalizing Europe’s banks only about half as big as it should have been as well as foolishly delayed until next June; the scheme for leveraging up the region’s safety net, the European Financial Stability Facility, is full of holes. This became clear at Cannes, where Merkel had to admit that few other G20 countries wanted to invest in it.

The whole of Europe is now in a race against time. The Greeks have to get their act together before the rest of Europe is ready to cut them loose. The Italians have to restore credibility before they get sucked into a vortex from which they can’t escape. And the rest need to put in place really strong contingency plans in case Athens and Rome continue to let them down. If everybody runs very fast, the last week could be the beginning of the catharsis. If not, chaos beckons.