01 September 2011

Stewart Fleming: Economic folly deserves humiliation

During the summer, with markets thin, it was only the European Central Bank's (ECB) deeply contentious intervention in the Italian and Spanish bond markets, beginning on 8 August, which prevented the spread of the sovereign debt crisis that has already gripped Greece, Ireland and Portugal. In return for this intervention, the ECB extracted its pound of flesh in a letter signed by both Jean-Claude Trichet, the bank's president, and his imminent successor, Mario Draghi, the fiercely independent governor of Italy's central bank. It demanded not just austerity, but a start to competitiveness and growth-enhancing structural economic reforms, designed in part to advance the deadlines from 2014 to 2013 for bringing budgets into balance.

History teaches that sovereign debt crises are resolved not just by providing bail-out funds but also by demanding overdue economic reforms in return. Provide too much money up-front and if the reforms come at all, they will come too little and too late. So bail-outs should only be heavily conditional and governments, even Italy's, should be forced to turn (humiliatingly) to the IMF, not just the ECB, for such support.

Given the scale and sources of the economic disaster that struck in August 2007, as economic historians Carmen Reinhart and Vincent Reinhart argued last week (28 August), growth may well remain sluggish for several years yet. So the summer slowdown in the economies may not be so much a signal that a double-dip recession is approaching as a manifestation of the ‘new normal' for the transatlantic economies. Lagarde is clearly right, however, to warn that the recovery will be derailed if Europe's leaders behave irresponsibly.

An early test of the eurozone's capacity to rise to the challenges is looming. Next week, Italy's parliament is scheduled to start debating the government's second emergency budget plan of the summer. It has, by law, 60 days to approve the proposals. Italian parliamentarians should not deceive themselves. If they show signs of balking at approving and implementing the still far-from-comprehensive reforms demanded by the ECB on 7 August, or seek to turn the reform process into a mere political football, then, within days, financial market speculators will be putting the Italian economy back on the rack.

Then, ECB intervention alone will not be able hold back a tsunami of destabilising market speculation. Indeed, in these circumstances, the ECB would be going beyond its legal mandate if it sought to protect Italy from the consequences of its own folly.

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