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After Berlusconi, euro zone should bring out heavy artillery

According to reports November 8, 2011, Berlusconi has agreed to resign, after the Italian Parliament passes economic reforms, when he conceded that he lost his majority in parliament.

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The euro zone should prepare to fire its bazooka when Silvio Berlusconi quits as Italian prime minister. Germany and the European Central Bank have been right to keep Rome on tenterhooks so long as it had a delinquent government. But even a credible new government could need help to get its borrowing costs under control and prevent a debt spiral that could destroy the single currency.

The ECB has the capacity to solve the euro crisis by acting as a lender of last resort to financially challenged governments, as there is no limit to the euros it can print. But the central bank – as well as Germany, the zone's main paymaster – have resisted this for three reasons. First, they are worried about inflation. Second, direct financing of governments contravenes the Lisbon Treaty. Third, they feel bailing out irresponsible governments will encourage continued bad behaviour.

The first concern is misplaced: inflation may be 3 per cent but, over the medium term, the bigger risk is deflation. The second worry can be overcome by designing the bazooka in a way that doesn't run foul of the treaty. That left the so-called moral hazard as the only valid reason for inaction – or, rather, limited action given that the ECB has been buying some Italian bonds in the market since August.

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Mr. Berlusconi has now said he will resign once key reforms have passed parliament. If Italy forms a new government that pushes through reforms to boost growth and brings down debt, its problems may be over. But don't count on it. Given Rome's loss of credibility in recent months, any post-Berlusconi market bounce could be short-lived.

The euro zone's current support mechanism – based on using elaborate financial engineering to leverage up the European Financial Stability Facility, the region's bail-out fund – is virtually dead. As a result, a real bazooka is needed. To get round the treaty's restrictions, the best way forward is probably for the ECB to lend to the EFSF to expand its firepower (or some variation on this scheme). The time for Germany and the ECB to hold their noses and back such an idea is fast approaching.

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