Hugo Dixon

Can the Italians be serious? That is likely to be the reaction of financial markets and the country’s euro zone partners as they ponder a disastrous election result, which could reignite the euro crisis. More than half of those who voted chose one of two comedians: Beppe Grillo, who really is a stand-up comic; and Silvio Berlusconi, who drove Italy to the edge of the abyss when he was last prime minister in 2011. Both are anti-euro populists.

This comedy could easily end in tragedy. The inconclusive result has echoes of last year’s first Greek election – except that Italy is bigger and more strategic. The country faces political paralysis, while its economy is shrinking and its debt is rising. The European Commission forecast last week that GDP would fall a further 1 percent this year after last’s year 2.2 percent drop. Debt, meanwhile, would reach 128 percent of GDP by the end of this year.

The euro crisis went into remission after the European Central Bank’s president Mario Draghi promised last summer to do “whatever it takes” to preserve the single currency. But, if Italy proves ungovernable during this critical time, even the ECB’s safety net may not work.

Investors are already getting nervous. Italian 10-year bond yields jumped 0.4 percentage points to 4.7 percent on Tuesday morning. Spanish yields also rose 0.2 percentage points to 5.3 percent, in the first sign of contagion. These are, though, admittedly still a far cry from the 7 percent-plus yields when the crisis was raging last July.

The risk is not that Berlusconi or Grillo will be prime minister. It is rather than nobody will be able to form a stable government. The electorate split into three roughly equal groups: Berlusconi’s centre-right group, Grillo’s uncategorisable 5-Star Movement and the centre-left coalition led by Pier Luigi Bersani. The centrist coalition led by Mario Monti, the technocratic who saved Italy from Berlusconi’s antics but whose austerity policies were deeply unpopular, came a poor fourth.

When euro zone governments agreed last year to give the European Central Bank the power to supervise its banks, that looked like another victory for its president Mario Draghi. It is more like a poisoned chalice.

The ECB will certainly get a chunk of extra power. But it will also be blamed when banks run into trouble, as they inevitably will. Draghi himself is experiencing this first hand following the scandal at Monte dei Paschi di Siena (MPS), which has had to be rescued by the Italian state. He has been lambasted for failing to supervise the country’s third largest bank properly when he ran the Bank of Italy – although the criticism seems overdone and has often been fuelled by his political opponents back in Rome.

The potential reputational risks for the ECB from banking snarl-ups on its watch are probably even bigger than they are for national central banks. This is because it doesn’t yet have the full set of tools to do the job properly. Moreover, a huge amount is at stake since the ECB is the euro zone’s most credible institution. If its reputation gets tarnished because of perceived supervisory failures, that could rub off on its ability to conduct monetary policy or manage crises effectively.

Who is Europe’s most powerful man? If one phrased the question as who is Europe’s most powerful person, the answer might well be Angela Merkel. But the deliberate use of the masculine excludes Germany’s chancellor, leaving the field open to Mario Draghi.

This answer can, of course, be disputed. How can one compare power in economics with power in, say, religion? Is it possible to rank the technocratic European Central Bank boss on the same scale, for example, as the Pope?

The best place to start is with an attempt to understand what power is. Bertrand Russell, the British philosopher, said it was the production of intended effects. By contrast, Steven Lukes, one of the top contemporary power theorists, said in an interview last week that power is the capacity to make a difference in a manner that is significant.

European integration tends to advance first with squabbling then with fudge. Every country has its national interest to defend. Some politicians appreciate the need to create a strong bloc that can compete effectively with the United States, China and other powers. But that imperative typically plays second fiddle to more parochial concerns with the result that time is lost and suboptimal solutions are chosen.

Amidst the europhoria unleashed by the European Central Bank’s bond-buying plan, it is easy to miss the immense challenges posed by two complex dossiers that have just landed on leaders’ desks: the proposed EADS/BAE merger; and a planned single banking supervisor.

Look first at the plan to create a defence and aerospace giant to rival America’s Boeing. This has been under discussion since at least 1997 when the UK’s Tony Blair, France’s Jacques Chirac and Germany’s Helmut Kohl called on the industry to unify in the face of U.S. competition. London, Paris and Berlin are the key players in this game because they have the major assets.

The European Central Bank’s bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone’s two large problem children and, with them, the single currency.

Mario Draghi’s promise in late July to do “whatever it takes” to preserve the euro has already had a dramatic impact on Madrid’s and Rome’s borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.

Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank’s financial firepower is theoretically unlimited, whereas the euro zone governments’ own bailout funds do not have enough money to rescue both Spain and Italy.

Can Super Mario save the euro? Mario Draghi said last Thursday that the European Central Bank’s job is to stop sovereign bond yields rising if these increases are caused by fears of a euro break-up. While this represents a sea-change in the ECB president’s thinking, it risks sowing dissension within his ranks. He will struggle to come up with the right tools to achieve his goals.

Draghi seemingly stared into the abyss and had a fright. Spanish 10-year bond yields shot up to 7.6 percent on July 24 while Italian ones rose to 6.6 percent. The high borrowing costs are not simply a reflection of the two countries’ high debts and struggling economies. Investors also fear “convertibility risk” – or the possibility that the euro will break up and they will get repaid in devalued pesetas and liras.

The central banker’s statement that dealing with convertibility risk is part of the ECB’s mandate is therefore highly significant. He rammed home his message, saying: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

The euro zone crisis is a multi-dimensional game of chicken. There isn’t just a standoff between the zone’s core and its periphery; there is also one between the European Central Bank and the euro zone governments over who should rescue the single currency. In such games somebody usually blinks. But if nobody does, the consequences will be terrible.

The brinkmanship between the governments is over how much help the northerners, led by Germany, should give the southerners. The core is effectively threatening the peripheral countries with bankruptcy if they don’t cut their deficits and reform their economies. The periphery is saying that, if they collapse, so will the entire single currency which has been so beneficial to Germany’s economy. The game is being played out transparently in Greece and covertly in Spain.

But even if the core eventually decides to help the periphery, there is a struggle of whether the aid should come from governments or from the ECB. Politicians would like the central bank to do the heavy lifting to avoid having to confront taxpayers with an explicit bill. But the ECB doesn’t think it is its job to help governments, arguing that such support violates the Maastricht Treaty.

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

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.