UPDATE 18 Dec 2011: While Europe is not out of the woods and the crisis far from over, Draghi's backdoor operation that I mentioned in the posting does have some effect in relieving the stress in the system. Bond yields of Eurozone countries have fallen across the board and there is renewed demand for European debt [Spanish, Italian Notes Gain as ECB Stokes Demand; Bunds Advance] especially 2 year bonds since ECB is offering 3 year loans. Italian 2yr paper fell from 8% to 5%..
Several weeks ago, I wrote that I believed the ECB would start printing money at some point in time because there is no other way to get of this crsis. The ESFS and ESM,bailout funds created by securing guarantees and financing from already indebted nations, are just not going to work. The Eurozone govts owe too much money and creditors are not convinced they will be paid back unless the ECB steps in. A number of govts in the Eurozone have collapsed, severe austerity has been implemented in PIIGS countries and riots are now frequent in a number of countries. Last week's summit proposed to have a "fiscal union" to put in place checks to prevent govts from overspending in the future. However, it does not address the current sovereign debt crisis - how creditors are assured they will get paid when there is no lender of last resort.
A few weeks ago, I thought that German intransigence was just a ploy to get other countries to play ball - impose austerity, and suffer for their past sins. After they get what they want, the ECB will have a free hand to print some money and the whole world can breathe a sigh of relief. The Japanese prints money to pay its debts...same goes for Britain and US. I was corrected by a number of commenters who informed me that what the Germans are doing is not for show - they are dead set against quantitative easing and will never let it happen. I did some checks and it turned out to be true - despite the disastrous consequences of a default by a Eurozone nation which will ultimately cause more pain and damage, the Germans are hard wired by their Weimar Republic experience never to allow money to be printed to pay debts. The Weimar Republic printed so much money it caused hyperinflation and wiped out the savings of ordinary Germans. The risk of another Weimar Republic is very small with the new fiscal pact in place enforcing discipline. One suggestion is for the ECB to lend to IMF so that IMF does the lending - with its experience of imposing austerity and discipline, monitoring and ensuring lenders gat paid, the crisis of confidence can be resolved. This and other solutions that involved the ECB printing money are opposed by Germany and it is politically impossible for Merkel to get agreement from her party's coalition partners. Even contribution to a bailout fund results in enormous political opposition in Germany as Germans do not want to pay for the overspending of other Eurozone govt - even though they are part of a union and another member's problem will spill into the German economy by way of contagion.
The instability in the Eurozone prompted one Pentagon official to warn of widespread unrest and a collapse of the union:
"We are extraordinarily concerned by the health and viability of the euro because in some ways we’re exposed literally to contracts but also because of the potential of civil unrest and break-up of the union,’’ - General Martin Dempsey, chair of the US Joint Chiefs of Staff. [Link].
So is the Eurozone heading towards chaos?
There are a number of silver linings in this whole mess. One of them in the form of Mario Draghi who became the ECB chief recently. He is Europe's version of Bernanke in the current crisis. He cut interest rates twice and took a page out of Bernanke's playbook by allowing Europeans banks to borrow money from ECB at 1% for 3 years using almost any kind of collateral including sovereign bonds. This is the same backdoor Bernanke created during the financial crisis allowing banks to put up any kind of collateral to borrow money. This will help to stabilise European banks and buy some time. In theory the banks can also now use the 1% loan to purchase Italian bonds that yield 6-7% as an indirect way for ECB to fund Eurozone govts[explanation of this backdoor]. This is a clever way around article 123 of the Eurozone treaty and avoid enraging the German Bundesbank
"We have a treaty and Article 123 prohibits financing of governments. We shouldn’t try to circumvent the spirit of the treaty" - Mario Draghi.
....and he has cover because the move is also needed to stabilise the banking system.
The other silver lining is probably Christine Lagarde who replaced the scandalous Strauss-Kahn. She has been proactively looking for solution to the crisis. One that involves IMF may emerge.
There risk of something economically dire happening grows over time as this crisis remains unsolved. The guys at PIMCO describe the situation as a snowball rolling downhill, it gets bigger with every failed attempt to stop it. At some point, this crisis will spin out of control and become too big to fix. Europe is going into recession and their debts will become even harder to pay back when the economy slows. The longer this crisis drags out, the more confidence is eroded and creditors abandon the Eurozone one by one....if countries like Italy cannot roll over its debt properly, they will default and that will be really derail the global economy.