Hugo Dixon

Mario Monti’s ability to take a crisis and turn it into an opportunity may one day be taught as a case study in political economy. When Italy’s technocratic premier succeeded Silvio Berlusconi last November, the country’s 10-year bond yield was above the 7 percent level that had driven Greece, Ireland and Portugal to seek bailouts. Now it is 5.5 percent – still high but moving in the right direction.

Countries with high debt levels like Italy – its borrowing is 120 percent of GDP – are prone to self-fulfilling prophecies on both the upside and the downside. If investors think a government will go bust, borrowing costs rise which, in turn, makes bankruptcy more likely. But if markets think it is solvent, borrowing costs fall and that means it’s unlikely to fail.

In Italy, where I spent much of last week, there have been spirals within spirals. One has been via domestic politics. Monti has so much credibility that he has been able to reform the pension system, liberalise a raft of monopolistic industries and launch a high-profile crackdown on tax evasion. That has helped cut Italian bond yields, further boosting his credibility.

Another spiral has been via international politics. The prime minister’s credibility was an important factor in convincing the European Central Bank to let euro zone banks borrow 500 billion euros before Christmas. Italy was the biggest beneficiary. Its banks are no longer staring into the abyss, with the result that the credit crunch which threatened to suffocate Italian industry is going to be less severe. Moreover, some of the ECB money is finding its way into government bonds, lowering Rome’s borrowing costs.

Monti’s credibility has also helped persuade Germany’s Angela Merkel to ease up a bit on her austerity mantra. One consequence is that, if Italy misses its target of a balanced budget next year, it is unlikely to be forced to tighten fiscal policy again – something that would risk sucking Italy into a Greek-style austerity spiral. President Barack Obama even complimented Monti during an audience last week, saying he had restored faith in Italy and generated confidence in Europe.

The contrast with the end of the Berlusconi era is stark. The then prime minister had little credibility at home and so was unable to push through reforms. He was considered a naughty boy abroad and so was cut no slack. He was shunned by Obama, being left to hang around with the likes of Russia’s Vladimir Putin and Libya’s Muammar Gaddafi. And spiralling bond yields pushed the country and its banking system to the brink, while tipping the economy into its current recession.

But Monti cannot declare victory. Yields are still high. The economy is forecast by the International Monetary Fund to shrink 2.2 percent this year. And the debt hasn’t gone away. This makes the country vulnerable to shocks such as a blow-up in Greece.

While there’s little Monti can do about short-term growth, he can get yields down further with three more measures: labour reform; structural reforms in tax and spending; and privatisation. Such reforms won’t have an immediate impact on productivity. But they would further enhance credibility and so cut Italy’s borrowing costs, giving further rapid twists to the virtuous spiral.

Monti is well on the way to tackling the labour market, with measures to make it easier to hire and fire people. He should also find it surprisingly easy to push these through given that his trust rating with the electorate is at an extremely high 57 percent, according to the Italian pollsters SWG. Even the radical pension reform, which increased retirement ages and cut benefits, provoked only a three-hour strike.

The new government has been more circumspect about fiscal reform. Here what is required is to cut waste and recycle the savings into lower taxes on employment. Similarly, Monti hasn’t committed himself to privatisation. Given that the state has assets worth over 1 trillion euros, it should be possible to sell off large chunks in a multiyear programme to cut the country’s debt well below 100 percent of GDP.

But the most fundamental change Monti could help engineer is in Italy’s self-serving culture where rules are not observed and cheating is given a nod and a wink. Berlusconi made that worse by going soft on tax evasion (which is estimated to cost 120 billion euros or nearly 8 percent of GDP a year), by using parliament as a tool of his personal interests and through his long-running battles with the judiciary.

Monti, by contrast, has started to change the discourse of politics. He is sober, not flamboyant – and comes across as honest. His crackdown on tax cheats has also created a stir. But he has pledged to resign after next year’s general election, meaning he has precious little time to bring about cultural changes.

The good news is that the people are thoroughly fed up with the current crop of politicians, who have an extraordinarily low trust rating of 12 percent according to SWG. That means there is a chance that new politicians could come in to fill the vacuum. The bankrupt electoral system which allows party bosses rather than the electorate to pick the MPs may be reformed. But there’s no guarantee of a clean sweep. What’s more, it seems unlikely that Monti’s successor will be as good as him – and it would be hard for the prime minister to stand for election himself without going back on his word and so undermining what he stands for. Still, he’s made a remarkable start.

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.

The euro zone’s future hangs on Italy – and Italy’s future hangs on its politics. The best way forward would be a grand coalition replacing Silvio Berlusconi’s discredited government. But after the prime minister’s Houdini act last week, that doesn’t seem likely and other scenarios aren’t as attractive.

Until recently, investors didn’t pay too much attention to the multi-dimensional chess game that is Italian politics. The state may have nearly 2 trillion euros of debt, equal to 120 percent of GDP,  but the country is rich: Net household wealth was 8.6 trillion euros in 2009, according to the Bank of Italy. The deal-making and back-stabbing in Rome – or for that matter, Berlusconi’s bunga-bunga sex parties – didn’t seem to matter. True, the country has virtually stopped growing in recent years. But there was even a view that Italy benefited from having politicians that were so concerned with their elaborate games that they couldn’t interfere with the business of business.

All that changed in early July. As the euro crisis gathered pace, scandals and wrangling in Rome unsettled markets. The 10-year bond yield, which had been a relatively comfortable 4.8 percent, shot up to 6 percent in two weeks. Berlusconi and Giulio Tremonti, his previously respected finance minister, fell out. The center-right government, which survives on a wafer-thin majority, was able to pass austerity measures to cut the deficit. But the actions were seen as too little, too late. Investors became hyper-sensitive to Italian politics and were no longer willing to take things on trust.

The rot was only stopped by the European Central Bank wading into the market in August and buying Italian bonds. But even this bought only temporary respite. Despite two European summits last week designed to provide a comprehensive solution to the euro crisis, Italian yields ended the week back at 6 percent. The country is on the edge of a debt spiral as investors’ concerns about the country become self-fulfilling. If borrowing costs rise further, the country’s debts won’t seem sustainable, meaning yields could shoot still higher.

The best way of breaking the vicious spiral would be to have a positive political shock – to counter the negative one delivered over the summer.  And the best way of achieving that would be to have a temporary grand coalition led by a technocrat such as Mario Monti, the former European Commissioner. Its mission would be to take harsh actions needed to solve Italy’s two big problems: debt and low growth. Labor markets would be liberalized; the bloated public sector would be cut down to size; and the over-generous pension system would be reformed. It might even be possible to reduce debt to below the psychologically important 100 percent mark by privatizing assets and instituting a one-off property tax.

Such an outcome doesn’t look likely. Although Berlusconi’s government has come close to collapsing several times in recent months, he has so far managed to pull it back from the brink. The latest crisis was caused by pressure last week from Germany and France to produce a stronger reform program. The Northern League, Berlusconi’s main coalition partner, balked at this. In the end, a compromise was struck which was just enough to satisfy the European allies but not too strong to bring the government down.

This was a pity. If the government had collapsed President Giorgio Napolitano would have been free to call on Monti or somebody else to form a technocratic government. As it is, Berlusconi will now limp on with a lackluster reform program which will struggle to secure the support of the market.

Even worse, the government may not be able to implement its program. The decisive vote in parliament probably won’t occur until January by which time another three months will have been wasted. What’s more, if the government falls at that point, the consensus in Rome — where I spent a few days last week — is that it will be hard for Napolitano to call on a technocrat to take charge and will instead be under pressure to agree to new elections. This is partly because Italy traditionally votes in the spring time and partly because the next elections have to be held anyway by mid-2013, meaning that a new technocratic government wouldn’t have much time to achieve anything.

New elections in, say, March might not be so bad if they delivered a decisive outcome. But Italy’s Byzantine politics make this far from certain. There are three blocs: the right, the left and the center. Current opinion polls show that the left would be the leading bloc but that it might not be able to form a majority without the support of the center. The center, though, is ideologically closer to the right – although it would be loath to join them in a coalition if Berlusconi was still around. Further complicating the picture is that fact that each of the blocks is made up of several parties each with its own agenda.

What all this means is that new elections could easily produce a messy outcome. Even a clear victory by the left wouldn’t necessarily be good. Pier Luigi Bersani, leader of Italy’s Democratic Party, the main left-wing group, hasn’t yet set out a clear agenda. Given that the party relies on support from unions, it might not be able to embrace the free-market reforms Italy needs.

There are, of course, other scenarios: Berlusconi may get his diluted program through parliament; his government may collapse before the end of the year, allowing a grand coalition to take over; even if it collapses in January, Napolitano may find a way of bringing in a technocratic government. Meanwhile, the euro zone last week agreed ways to leverage the European Financial Stability Facility, its bailout fund. This means it should soon have a much bigger war-chest with which to support Italy if its bond yields climb higher. But the EFSF’s resources are not limitless. If Italian politics remains dysfunctional, Europe could soon be back in crisis mode.

The euro zone is like Hotel California, UBS wrote in a report published in September. “You can check out any time you like but you can never leave,” it said, quoting the Eagles song. A British businessman, Simon Wolfson, has now offered a 250,000 pound prize to the person who can come up with the most convincing explanation of how an orderly exit from the single currency is possible.

The problem is the word “orderly.” There are lots of scenarios where a country such as Greece could quit the euro in a disorderly fashion, destroying its own economy and that of its neighbous as well as possibly plunging the world into a recession. But how is it possible to do this without triggering financial Armageddon?

The first difficulty stems from the fact that an exit couldn’t happen overnight. There is no legal procedure for a country to quit. Joining was supposed to be an irrevocable commitment.

Treaties can, of course, be renegotiated or broken. But this couldn’t happen rapidly -– or, more to the point, secretly. There are 17 members of the euro zone; and another 10 European Union members such as the United Kingdom, which don’t use the single currency. If Greece wanted to reintroduce the drachma, it would have to secure the unanimous agreement of these other nations. It is also inconceivable that it could take such a momentous decision without discussing it in parliament. Predict weeks, if not months, of heated wrangling.

Such debate would frighten the horses. Many depositors have already removed their savings from Greek banks. An open discussion about Athens leaving the euro would trigger a stampede. The whole point of bringing back the drachma would be to devalue it in the hope of making Greek industry competitive. Analysts think the initial fall might be 50 percent. If so, anybody patriotic enough to keep their money in a Greek bank would lose half their savings.

Transitional mayhem
Athens could then do three things: allow its banks to collapse; appeal to its euro partners for help; or impose controls on how much money people could take out of its banks.

Allowing banks to collapse in a disorderly fashion would be mad. It would be a sure-fire way to cause economic chaos and social disorder. The recent street protests would seem like a tea party.

Getting help from the euro zone would be ideal. But why would its euro partners want to bail out Greece’s banks, if the country was on the point of quitting the euro? The European Central Bank has already stopped making new loans directly to some Greek banks because they have run out of high-quality collateral. Instead, it has authorised the Greek central bank to provide liquidity, with Athens theoretically on the hook for any losses. But if Greece was about to quit the euro, the ECB would be worried that it would never get paid back. It would hardly want to authorize yet more lending as this could just increase the size of its future losses.

So Athens’ only choice would be to control how much people could take out of their accounts. It would be like wartime –- with savings rationed instead of butter and bread. This wouldn’t be as bad as allowing banks to collapse. But it would still plunge the country deeper into misery.

Brave new economy
The hope, of course, would be that Greece would eventually rebound on the back of a super-competitive drachma. Northern Europeans would flock to its beaches to enjoy half-price retsina and feta. Maybe. But there would be two other questions: how would the government finance itself; and how would inflation be contained?

Athens has too much debt. The latest forecast from the Troika (made up of the International Monetary Fund, the ECB and the European Commission) is that debt will reach 183 percent of GDP by the end of next year. That debt load will loom even bigger if Greece quit the euro. In drachma terms, assuming again a 50 percent devaluation, debt would rocket to 366 percent of GDP. The government has to default even if it stays in the euro; but the extent of the haircut would be bigger if it quits.

Greece also has a primary budget deficit: it is earning less than it spends even before interest payments. A unilateral default would make it a pariah state. Nobody would lend it money to finance its ongoing deficits. That would provoke an even more severe recession in the short run. The government would also be tempted to print lots of new drachmas to fill the hole in its coffers, fueling inflation and debasing the currency.

To avoid such a nightmare scenario, Greece would need to secure an orderly default if it quit the euro. The best hope of achieving that would be to cut a new agreement with the IMF. Most but not all of its debts would be cancelled. But it would have to agree to tight fiscal and monetary policies to make sure it didn’t run up new debts or descend into hyperinflation. In return, it would get some hard currency to manage the transition. But even with such a balm, the journey would be painful.

Vicious contagion
Unfortunately, the problems with a Greek exit from the euro would not stop with Greece. Contagion would be far more virulent than anything witnessed so far.

Seeing what was happening to Greek depositors, savers in Ireland, Portugal, Spain and Italy — and possibly even France and other countries — would run a mile. They would take their euros and deposit them in German, Dutch or Finnish banks. To stop a large chunk of Europe’s banking system collapsing, the ECB would have to authorise unlimited supplies of liquidity for an indefinite period of time.

The key decision would be whether to let any other countries go the way of Greece. Portugal would be seen as next in line because of its need to improve competitiveness. But Lisbon would probably not want to quit. Given that there’s no time to waste in the midst of a bank run, the least bad option would be to rally around all the remaining euro countries and insist they were permanent members of the club.

It might, though, be sensible to take the opportunity of a Greek exit from the euro to arrange simultaneously an orderly default of Portugal and perhaps Ireland while keeping them in the single currency. If their debt levels were cut to more sustainable levels, they would be in a better shape to withstand the whirlwind unleashed by Athens’ departure.

Wherever the line was drawn, it would have to be defended to the hilt. This wouldn’t just be about protecting depositors. Bond investors would believe more departures from the single currency were on their way. Portugal and Ireland don’t matter for the time being because they are supported by euro zone and IMF bailout programmes which don’t require them to tap the market for new money. But Italy and Spain, which are already suffering jitters, would be shut out of the market.

The convulsions from a bankruptcy of Italy, whose debt is nearly 2 trillion euros, would be so seismic that it shouldn’t be attempted unless there really is no alternative. But rescues by other governments wouldn’t be possible either. The region’s bailout fund, the European Financial Stability Facility, isn’t remotely big enough.

Financial jiggery-pokery — such as turning the EFSF into an insurance company to leverage its firepower — might just work in the current circumstances. But it wouldn’t have credibility if Greece was quitting the euro and there were bank runs across the continent. The best way to hold the line would be for the ECB to provide unlimited supplies of liquidity to struggling nations by massively expanding its purchases of Italian, Spanish and other sovereign bonds in the secondary market.

The good thing about the ECB is that there is theoretically no ceiling on how many euros it can print. The problem is that massive liquidity injections to both banks and governments could remove the incentive for lenders and countries to manage their affairs wisely. Once the storm had passed, it would be best to separate the illiquid institutions or governments from the insolvent ones and find a way of restructuring the debts of the latter in an orderly fashion.

But faced with the choice between an imploding euro zone or underwriting delinquency, the ECB would be best advised at least initially to plump for the latter even if that would involve eating its words. Still, there’s no disguising that it would be an unpleasant outcome.

An orderly exit from the euro is a virtual oxymoron. There are ways to minimize the damage –- principally by rationing access to savings during the transition, orchestrating an orderly default of the country that quits and unleashing the ECB as a lender of last resort to those that remain. Even with such a program, the economic damage would be huge. Without it, staying in Hotel California would seem like a holiday. The euro zone would become a towering inferno with everybody scrambling for the exits.

PHOTO: A banner featuring a Euro coin is seen on the European Commission headquarters building ahead of a European Union heads of state summit in Brussels October 26, 2011. REUTERS/Yves Herman