The euro crisis has been about Italy for some time now. The October 27 announcements had the right main ideas, but lacked detail and were insufficient in magnitude. Because the main ideas had been floated back in the IMF Meetings (Sept. 23-25), markets had recovered somewhat during October, making conceptual announcements insufficient. Given the political constraints that seem to operate in most of the rich EU countries, the only player with the capacity to stabilize the euro is the European Central Bank (ECB). Like in many international finance issues, it is not about capacity, but willingness. Mario Draghi (ECB President) has to lead jointly with Merkel and Sarkozy.

The October 27 announcements contained what is necessary to stabilize the euro and buy time until the necessary reforms to the underlying institutions can be implemented, which is one ingredient to having growth resume in the region. Even though we are only talking about buying time, EU authorities tried to short-change the markets once again. The three main efforts, correctly so, were a deeper Greek debt restructuring, bank recapitalization across the region, and a credible fence to protect Italy/Spain/Portugal/Ireland from contagion. On bank recapitalization and on the fence, the announcements were vague. Political constrains seem to prevent to EFSF from being expanded with new resources, so it has to be leveraged (or use as an insurance company). National governments, especially in the richer countries, can pitch in for bank recapitalization, which makes the smallish announcement less of a problem (they announced less than 150 billion euros, when most private estimates are higher than 200 billion, with some around 400 billion).

With the EFSF being clearly insufficient, and the leverage or insurance mechanisms being still unclear, the authorities seem to be trying to get contributions from the new cash-rich countries: China, Brazil, etc. Ironies aside, the Chinese have publicly said they would be willing to help, but not until there is more details.

Given the size of Italy’s debt, any optimistic but realistic assumption about a contribution from emerging economies cannot change the story. Thus, we are left with the ECB, which has so far indicated it does not want to be seen as the lender of last resort, and does not want to act as the Fed (in terms of balance sheet expansion). There is a significant gap between words and actions, as the ECB has reluctantly been buying debt from Spain and Italy. More importantly, many things the ECB had said it would not do, it has done.

The ECB needs to be an active and eloquent part of the plan to eliminate contagion. A partial reluctant effort while saying it is only transitory does not instill any credibility, it actually undermines the action. The ECB has to come out to say that the stability of the euro depends on avoiding a liquidity crisis to evolve into a solvency crisis in Italy and Spain, and actively and credibly intervene in the markets towards that goal. Countries have to work towards their own sustainability, and they cannot rely on life support from the ECB forever. But in order to avoid an endogenous solvency crisis in Italy, the ECB has to intervene in a credible fashion. Maybe the IMF can channel the help from emerging nations, but that is a subsequent complement, as it is more difficult and limited.

Some can argue that the ECB is young and cannot jeopardize its credibility like this. Moreover, the original sin that led to this crisis of the euro was the Maastricht violations by France and Germany. These are good arguments. There are two possible scenarios, then: 1) let insolvent and soon to be insolvent countries to restructure their debt (some might exit the euro), which requires significant bank recapitalization across the region; or, 2) make Greece a clear exception, protect the solvency of the rest by credibly fending off contagion. If the EU is a medium-term project that will eventually look more like a country and less like a customs union with an ad hoc monetary union, then they need to choose scenario 2, which requires the ECB to overcome some self imposed limitations. True that Mario will need political backing, potentially some tweaks of its mandate. But the alternative seems to be far worse.

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