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Days of Decision for Europe

As much as I detest the Fed’s emergency lending programs to banks to get them through the crisis, the truth is that they were fulfilling a main responsibility of central banks. It’s that they stopped following through when the crisis turned to human beings and not financial institutions, and that they were so generous (to the point of giving free money to banks), that was the big problem.

But if the Fed were running Europe today, the situation would demand at least a somewhat similar operation to get the continent out of crisis. Yet the European Central Bank, what passes for a facsimile, believes it has only a mandate on price stability and refuses to become that lender of last resort. And that is why some like Wolfgang Munchau in the Financial Times believe there may only be days left to save the Eurozone:

In virtually all the debates about the eurozone I have been engaged in, someone usually makes the point that it is only when things get bad enough, the politicians finally act – eurobond, debt monetisation, quantitative easing, whatever. I am not so sure. The argument ignores the problem of acute collective action. Last week, the crisis reached a new qualitative stage. With the spectacular flop of the German bond auction and the alarming rise in short-term rates in Spain and Italy, the government bond market across the eurozone has ceased to function.

The banking sector, too, is broken. Important parts of the eurozone economy are cut off from credit. The eurozone is now subject to a run by global investors, and a quiet bank run among its citizens. This massive erosion of trust has also destroyed the main plank of the rescue strategy. The European Financial Stability Facility derives its firepower from the guarantees of its shareholders. As the crisis has spread to France, Belgium, the Netherlands and Austria, the EFSF itself is affected by the contagious spread of the disease. Unless something very drastic happens, the eurozone could break up very soon.

Even before the final reckoning, Europe has slipped into recession. The OECD’s prescription for this, sadly, is more austerity. But even they say that the ECB is the only entity equipped to arrest the crisis. All we’re hearing are trial balloons about the IMF rescuing Italy, which have since been shot down. But that would be the ECB funding the IMF, in all likelihood. Which is why it wasn’t credible.

As Munchau reports, European banks cannot secure market lending. It turns out the banks got stuck with a lot of the shitpile – bad mortgages, toxic loans – and now the music has stopped and they cannot find a chair.

The options are only a massive backstop from the ECB, perhaps eurobonds to spread risk among all 17 member countries and lower total borrowing costs throughout the Eurozone, and tighter fiscal integration, which is being discussed. But all of these involve the political actors of the major countries to give up the most cherished element of nationhood, sovereignty. I don’t know how all these competing forces get together on such a deal to turn European countries into the United States of Europe. And even in the event of success, changing treaties and constitutions with referenda could take years. The Eurozone has days.

And none of this misses the United States. The combination of Euro fallout and the likely fiscal drag from forced spending cuts is enough to bring us to a recession as well.

More from Tim Duy. I don’t see much reason for optimism.

UPDATE: More gloom from Peter Boone and Simon Johnson. The failure late last week of a German bond sale, which could not find enough investors, shows that contagion has reached the strongest country in the Eurozone. Boone and Johnson basically recommend a limited breakup, which may be where we’re headed anyway.

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David Dayen

David Dayen