The surprising history of Italy and sovereign default

Italy doesn't do sovereign default (Photo: Getty)

There is a great deal of wild talk in financial markets about how Italy is "bankrupt", about how default there is "inevitable", and how it would be an Italian default that brought down the euro (rather than Italian default, or depreciation in its currency relative to the German currency, being a risk in the event that the euro collapses - my own view). During the past couple of years we have become used to stories of how common sovereign default has been for Greece, over the past 170 years. But how many people are aware of how often Italy has defaulted, historically?

Well, readers may remember – if they ever read my blogs, at least – that Italy faced a similar debt to GDP ratio to today in the 1990s, without defaulting or inflating or growing fast, and did so at higher interest rates than it is being charged even at current elevated levels. But do they remember when it last did default?

It being the 2010s, presumably readers will rush off now to check out the Wikipedia entry on sovereign defaults. You will find no entry for Italy there. That list is incomplete in a number of regards – for example, it does not include the defaults of France and Britain on their First World War debts to the US in the early 1930s. France began defaulting in 1932. Britain began defaulting in 1933. Italy – which of course was one of the allies of France and Britain in the First World War – was the last World War I ally to default. The only Italian default I can identify, historically, was that from 1940, when it suspended payments to its then World War II enemies.

Sovereign default is almost always a choice – a matter of appetite to pay, rather than ability. Britain and France were not out of assets in the 1930s, any more than Greece is out of assets now. Because it is a matter of choice, it is a reflection, as much as anything, of culture and history. Italy simply has no history of peacetime sovereign default. It doesn't do it. Instead, it has a history of having borne very large government debt to GDP ratios and paid. That is one key reason it has found it possible to build up such a high debt to GDP ratio.

This doesn't in itself prove that the Italians will not default this time. But it is one very important way in which Italy is totally unlike Greece.

Sorry, there is no euro break-up plan – yet

Reports of plans for a break-up of the euro are premature

Very quickly, I have grave reservations about the Reuters story claiming that top German and French officials have had "intense consultations" on plans to reshape or "prune" the currency bloc, reducing it to a manageable core.

The Brussels press corps do not believe it. Nobody seems to know which German official is briefing behind the scenes that "you’ll still call it the euro, but there will be fewer countries."

The claims do not remotely reflect the stated position of Chancellor Merkel and President Nicolas Sarkozy. Merkozy might like to see Greece tossed to the wolves. That is a different matter.

There is a drive for a core Europe or "Avant-Garde" that pushes ahead with closer union, but that is mostly directed against the UK and other members of the awkward squad. Reuters seem to have conflated two separate issues.

The reality is that EU leaders are still unwilling to contemplate an orderly break-up of monetary union, or to deploy the system’s dwindling reserve of credibility to prepare for this traumatic moment.

To the extent that the Reuters story catches one vein of thought in EU capitals, it is about forcing weak states to leave EMU. This is the worst possible outcome. It can only set off a chain reaction, ultimately engulfing France. At that point the whole eurozone would spiral into a catastrophic depression – if it is not already. Germany itself would be ruined.

My own proposal – like that of Hans-Olaf Henkel, the former head of Germany’s BDI industry confederation – has long been for a radically different kind of break-up. Germany and its satellites should leave, bequeathing the euro, the ECB and other EMU institutions to a Latin union led by France. The euro debt contracts of the south would remain intact. (It is crucial that France stays in the southern bloc, otherwise the instant devaluation of the south would be too great, and France’s banks would blow up on Italian debt)

If conducted skilfully, the revalued Teutonic Thaler could be held by exchange and capital controls at a 30pc premium for long enough to stabilise the two systems. Ultimately each side would get what it wants: Germany could enjoy the stronger currency it needs; the south would restore labour competitiveness without having to go through a decade of grinding deflationary slump. This itself would reduce the risk of defaults. I suspect that within five years, the Latin half would prove to be the more dynamic bloc.

Obviously Germany, Holland etc would have to recapitalise banks to absorb the shock of 30pc FX losses on their Club Med bonds. The banking system might have to be nationalised. So what? This would be much cheaper than the trillions now needed to prop up EMU’s rotten edifice. It addresses the core problem of north-south currency misalignment within EMU that lies behind the whole crisis. Unfortunately, neither Berlin nor Paris seem ready to think along these lines. It would require a complete purge of the political elites in both countries.

Given this strategic fact – and given the risk that Europe will take us all hurtling into disaster – the authorities must instead step up to the plate and deploy the ECB as a lender of last resort to halt the debt spiral. (Yes, the ECB may be incapable of playing this role, since it has no sovereign indemnity. That is a risk. All possible outcomes are by now fraught with danger.)

This must be backed by a broader switch away from 1930s Laval-Bruning liquidationist and contraction policies. There is no justification for allowing real M1 deposits to contract across most of the eurozone – and to plunge in the south – as has occurred over recent months. For a monetarist central bank, the ECB is remarkably insouciant about money.

The EU must slow the pace of fiscal contraction and launch a monetary blitz to lift the south out of chronic depression. A 5pc nominal GDP growth target for euroland for as long as it takes would do the trick. I believe central banks have the capability to deliver such result.

Let me be clear, this is not my preference. It would better for greater Germany to leave EMU. But given the evidence so far that Germania has no intention of taking such a course, it must instead drop its opposition to the sort of radical reflation stimulus so obviously needed to save monetary union and avoid a savage slump.

What Germany cannot continue to do is to refuse to leave EMU, and refuse to reflate. This is not a policy. The rest of the world is entirely entitled to make its irritation known.

America and China must crush Germany into submission

Barack Obama greets Hu Jintao, the Chinese President (Photo: AP)

As we watch Italy's 10-year bond yields near 7.5pc and threaten to detonate the explosive charge on €1.9 trillion of debt, it is time for the world to reimpose order.

You cannot allow the biggest bankruptcy in history to run its course – with calamitous domino implications – before all options have been exhausted.

One can only guess what is happening in the great global centres of power, but it would not surprise me if US President Barack Obama and China's Hu Jintao start to intervene very soon, in unison and with massive diplomatic force.

One can imagine joint telephone calls to Chancellor Angela Merkel more or less ordering her country to face up to the implications of the monetary union that Germany itself created and ran (badly).

Yes, this means mobilizing the full-firepower of the ECB – with a pledge to change EU Treaty law and the bank's mandate – and perhaps some form of quantum leap towards a fiscal and debt union.

Germany will of course try to say no. But it will pay a catastrophic diplomatic and political price, and will fail to save its economy anyway if it does so.

Having followed the German political scene closely for the last five months, it is clear to me that almost the entire German political establishment is out of its depth, ideological, sometimes smug, apt to view the EMU debt-crisis as a Calvinist morality tale, and lacking in deep understanding of what it has got itself into.

One can understand German worries about money printing – and especially the loss of fiscal sovereignty and democratic control – but matters have already moved on. It is too late for that.

As for the EU authorities with their mad contractionary fiscal and monetary policies in an accelerating slump, they seem to have achieved little by toppling two elected governments in one week.

In Italy they have already made matters worse. I doubt that much will change with "technocratic governments" in either Greece and Italy, yet immense damage has been done to democratic accountability.

The EU Project has become both dangerous and insane.

 

Once Greece goes, the whole euro project will unravel

Robert Jenkins, a member of the Bank of England's Financial Policy Committee, does a good job in setting out the potentially disastrous economic and financial consequences for Greece and the wider European Union if Greece is allowed to default via exiting the eurozone in this morning's FT (£).

That possibility was admitted for the first time by eurozone leaders at the Cannes summit last week. Obey or leave the club, was their message. But as Mr Jenkins explains, the consequences, not just for Greece but everyone else in the eurozone would be potentially catastrophic. Once Greece goes, the other PIGS would sit there like ducks in a row, waiting to be picked off one by one, or perhaps all in one go.

However, there are two problems with the implication of his analysis, which is that Greece cannot be allowed to leave and must therefore be restructured within the single currency. One is that the realpolitik of the eurozone is preventing the application of sensible policy to ease the plight of the periphery and allow the resumption of reasonable economic growth.

The short term consequences of a breakup may be extraordinarily traumatic, but the long term costs of staying together look pretty unappetising too. Far from promoting growth and political solidarity, which is what the single currency was supposed to do, the euro is infact achieving the opposite effect, by condemning the eurozone to long term recession and now extreme political infighting.

By suggesting that there will be no support for Italian bond markets until Italy reforms itself, the European Central Bank is playing god in a way which is almost certain to end badly. Whatever Silvio Berlusconi's faults, which are undoubtedly many, since when was it thought acceptable for the central bank to effectively decide on what the government in Italy should be?

Italy on the brink as yields soar past point of no return

The eurozone debt crisis has again conformed to pattern this morning; just as one fire abates, temporarily at least – with news of the formation of a government of national unity in Greece – another lights up. Lamentably, this one – Italy – may be too big to douse.

The yield on ten year Italian debt rose to 6.59pc this morning, widening the spread on German bunds to an unprecedented 4.81pc. These are the sort of levels at which Greece, Ireland and Portugal began to find themselves shut out of markets.

Yet this time, there appears nothing there to offer support. The "enlarged" European Financial Stability Facility is not yet up and running. Few seem prepared to offer it the "leverage" required for the mooted €1 trillion of fire power. The European Central Bank under its new president, Mario Draghi, has said it's not its job to act as "lender of last resort" to governments. And the new funds that would allow the International Monetary Fund to step into the breach have not yet been agreed.

Internationally, moreover, there is growing resentment at being called apon to support further EFSF and IMF bailouts. Christine Lagarde, managing director of the IMF, could soon have a full scale rebellion on her hands. From China to Brazil, the now openly spoken mantra is that Europe should sort out its own problems. By what right does one of the world's richest regions call on poorer, and sometimes even more indebted, nations to lend support?

As my colleague, Ambrose Evans-Pritchard, points out in this morning's Daily Telegraph, the problem with Italy is not really one of contagion from the rest of the eurozone periphery. It's much more to do with the fact that Italy is sliding into deep recession, further undermining already stressed debt dynamics.

There's a vicious circle at work, whereby more austerity equals less demand, equals negative growth, equals an even bigger debt burden. Unlike Britain, there is no monetary policy and devaluation to counter the economically debilitating effect of the fiscal squeeze. With growing lack of competitiveness, Italy is in the wrong currency.

At his first press conference last week as ECB president, Mr Draghi said that further bond purchases would be "temporary", "limited" and "justified on the basis of restoring the functioning of meonetary policy transmission channels". At Jefferies International, chief economist David Owen takes the view that whatever Mr Draghi said last week, in practice he'll be forced to change tack and make the promise of "unlimited" buying explicit. But even if he did, would it really do the trick?

Mr Draghi would have preferred to exhaust conventional measures first, in particular cutting interest rates all the way down to 0.5pc, but conditions in the Italian bond market are deteriorating with such speed that he may not be allowed that luxury. When a fiscal crisis developes, it tends to happen very fast, with the rapid ebbing away of what remains of market confidence. That's the place Italy now finds itself in.

Eurozone policymakers think they are already moving at a speed which is only barely compatible with continued democratic support. Yet they are going to have to move even more swiftly towards the introduction of eurobonds and a centralised eurozone treasury function if they are to save the project. Germany and other rich, creditor eurozone nations are going to have to make up their minds; they wanted the euro, but are they prepared to do what it takes to sustain it?

America ignores long-term unemployment at its peril

It wasn’t great, good or, depending on whether your glass is always half full or empty, even that encouraging. But there was nothing in the latest US jobs report that has had anyone borrowing the doom-laden language that Europe has had a recent monopoly on.

80,000 jobs were created in October, and the tally for August and September was revised upwards by a total of 102,000. According to the Bureau of Labor, people have been hired at a rate of 125,000 a month for the last year. There was a decline, too, in the long-term unemployed – a group you belong to in the US if you’ve been without work for more than six months. That figure fell 366,000 to 5.9m.

But don’t expect Americans to be celebrating. That’s not only because October’s figures don’t immediately change an extremely difficult jobs market. 13.9m people are still unemployed and a further 8.9m are having to settle for part-time work. It runs deeper.

The high level of unemployment America has had since the financial crisis is a wound to its self-esteem. This is a country that built itself on being able to offer work to those who can’t find it where they’re from. And if they do have it, there's always been the promise of better paid and more interesting work on offer in the US.

I was talking to a businessman this week who had built a company that now employs more than 20,000 people. The mention of the unemployment rate prompted an almost physical reaction in him as if a bad smell had entered the room. And nowhere is the assault on the US psyche stronger than in the scale of long-term unemployed this downturn has created.

A report published this week by the Pew Trust, a bipartisan research group, underlines what a new problem it is. Before spiking to its current level of 42.2pc of the total number of unemployed, the highest it reached since the 1960s was just under 15pc following the recession of the early 1980s.

In its analysis of long-term unemployment in the third quarter of this year – July to September – The Pew Trust report found that older workers were hit particularly hard. 43pc of those without work over the age of 55 had been for more than six months. A university degree did not offer that much protection – 34pc of the unemployed with a degree were long-term casualties, while almost every industry had 20pc long-term unemployment.

Because it’s a new phenomenon, it’s bringing new headaches for America’s policymakers.

The safety net for those who can’t get work was strengthened in 2009, when the period people can claim unemployment benefits for was extended from 26 weeks to up to 99 weeks. That has come at a cost. The Congressional Budget Office estimates that $160bn was spent on unemployment benefits in 2010 compared with $33bn in 2007. The 99 week extension is due to expire in January, and despite the fierce political debate the issue provokes, it would be a surprise if Congress does not extend it for 2012.

The far more testing issue is how to unwind the problem. America has barely started. The state of Georgia has pioneered a programme in which the long-term unemployed continue to receive benefits while working at a company for a while in the hope that they will be hired on a permanent basis. Though it’s had mixed results, President Barack Obama is pushing for a nationwide variation as part of his $447bn American Jobs Act.

Meanwhile, Federal Reserve chairman Ben Bernanke has consistently voiced his anxiety about the problem. But much of the central bank’s ammunition has been fired and there’s a limited amount that monetary policy can do on its own to address the long-term unemployed. Although October’s figures recorded a decline in their numbers, the danger and greater risk is that the problem deepens.

The consensus among economists is that the majority of unemployment is what they describe as cyclical. In other words, as the economy recovers companies will hire more aggressively and those without work will find it. But at an otherwise dull press conference on Wednesday, Bernanke remarked that: “cyclical unemployment left untreated can, so to speak, become structural.”

The implication is worrying: a period out of work can turn a previously employable worker into one that will find it much harder to get a job. Skills atrophy, confidence plummets and the needs of companies

move on.

Precisely because long-term unemployment is such an affront to America’s self-image, it’s one that the country surely needs to put more energy into understanding and trying to solve.

Italy is neither insolvent nor illiquid

Italy's debt problems are not crippling

Regular readers of mine will know that, whilst I have long regarded Greece as certain to default and very likely to leave the euro, I have been very sceptical about the idea that there is any significant problem with Italy.

Recent days have seen a spiking up in Italian bond yields and a rise in the spread over German bunds.  Many commentators are now suggesting or implying that we are approaching the point at which a liquidity crisis for Italy might turn into a solvency crisis.

I find this an extraordinary claim, greatly at variance with the data and historic experience.  If it is in any sense true, that can only be for the most brutish of political reasons.

As I write, Italian ten-year bond yields are hovering at around 6.4 per cent, a euro-era high.  But why should we imagine, in any way, that that implied Italy had a solvency problem (or even a liquidity problem).  Consider the chart:

Here we see that recent bond yields do indeed constitute euro-era highs.  But before the euro, Italy had far higher yields and did not default.  If it did not default then, why would it default now?  Perhaps you think it used the period of low interest rates to accumulate extra debt?  Not so.  Current Italian debt-to-GDP is around 120 per cent of GDP, about the same as it was in the early 1990s.  And it isn’t accumulating additional debt especially fast – even during the recession itself, whilst deficits elsewhere rocketed into double figures, Italy's peaked at 5.4 percent in 2009 (less than, for example, France's 7.5 per cent).

So if even if Italy were simply to pay current market rates on its debts, it would be paying lower interest rates on no more debt than it serviced in the 1990s without defaulting. (Indeed, a recent Bank of Italy stress test suggested that debts would be sustainable even at 8%.) Why would it default this time?

Maybe you think that before the euro, Italy inflated away its debts?  Consider the following graph:

It is true that Italian inflation was higher in the early 1990s than today.  Then it was around 4 per cent, now it’s around 3 per cent.  Is that 1 per cent difference really the difference between defaulting and not – especially given that today’s interest rates are still 2-6 per cent below those in the 1990s?

Well, maybe real GDP grew faster then than it will now?  Maybe, maybe not.  In the seven years from 1992 to 1998, Italian GDP grew at 1.3 per cent per year in real terms — hardly stunning, but it didn’t default.

Finally, perhaps we worry that the capacity of the Italian population to deal with increased taxes to service Italy’s debts is less than in the past?  But by 2007, Italian household debt was only 30 per cent of GDP (versus around 60 per cent in Germany, nearly 70 per cent in the UK, and around 80 per cent in Ireland, Spain and Portugal). Whilst the UK, Ireland, Belgium and the Netherlands all have banking sectors of 350-450 per cent of GDP, the Italian banking sector is one of the smallest, relative to GDP, in the eurozone, at only around 150 per cent of GDP (only around the same size as Finland's).

I see nothing in any of these numbers to indicate that Italy would find any more interest in defaulting on its debts now than it did 20 years ago.  Of course, were the euro to disintegrate for other reasons – if, say, Germany left – then there is a fair chance that Italy’s post-euro currency would depreciate versus the post-euro German currency.  And if everyone else were then defaulting, perhaps Italy would join the party.

But, as matters stand, I see no reason why Italy should not simply live with the kind of yields markets currently demand of it.  I believe it should keep rolling over its debt, according to schedule.  It should, as it were, embrace the markets, saying “If the price is 6 per cent, I’ll pay 6 per cent.  If the price is 7 per cent, I’ll pay 7 per cent – because Italy is going to service her debts.”  If Italy embraces the markets, and shows its willingness to pay, then markets are likely to recover their confidence.

Italy should take no money from the IMF, and no money from the EFSF. Taking from either source would be little short of economic suicide, as it would indicate that Italy were not willing to pay interest rates available in markets that are perfectly serviceable.

Italy does not have a solvency problem.  Neither does it, in fact, have any particular liquidity problem — its bond auctions have shown no more tendency to fail than those elsewhere.  And the prices it needs to pay to roll over its debts are not so high as to threaten Italy’s solvency.

The euro has a problem, and euro problems elsewhere could become Italian problems.  And Italy may have problems of political organisation or comprehension of the issues.  But, within the euro, it is not insolvent.

Dear Archbish – do shut up

Stick to the sermons, Archbishop

Religion and commerce never mix well, but for Rowan Williams, the Archbishop of Canterbury, to throw himself onto the bandwagon already occupied by the Vatican, Jose Manuel Barroso, Uncle Tom Cobley and all, and back calls for a "Robin Hood" tax on financial transactions demonstrates very little understanding of the real world.

This is one of those superficially attractive ideas that in practice would have catastrophic consequences for the UK economy for no obvious benefit other than to the freeloaders of the European Commission.

The Archbishop claims to share the "the widespread and deep exasperation with the financial establishment" and thinks that a Tobin tax might even things out a bit if it were used to support the UK economy and international aid.

Nobody would quarrel with the proposition that financial services should be required to pay their fair contribution to the wider economy, but unfortunately a Robin Hood tax would go much further and very likely succeed in driving much of the industry from these shores altogether. In the long run, that's not going to benefit the UK economy, or indeed international aid.

As it happens, Dr Williams' intervention coincides with a letter to George Osborne, the Chancellor, from Andrew Tyrie, chairman of the Commons Treasury Committee, raising a number of concerns about the tax. Chief among these is that it might be imposed on us by Europe. Indeed, that's precisely what the European Commission is proposing to do.

This in itself would be a direct infringement of the independence of UK fiscal policy. As things stand, Europe does not set our taxes. It's one of the few things we still decide for ourselves. What's more, the Commission proposes that the proceeds be applied to the EU budget, contributing an estimated 23pc of the total by 2020. Since London is far and away Europe's biggest financial centre, accounting for the bulk of international trading in everything from foreign exchange to credit default swaps, it would by implication signficantly increase the UK's effective contribution to the EU budget.

There's no appetite for such a tax on a global level right now – the Americans are dead against it – so to impose it on the City would in time result in much of the business shifting off shore. It's hard to see how that could be in the UK's interests. You can throw the money changers out of the temple if you like, but they will still be with us; it's just that we won't be able to tax or control them.

Oddly, it's often thought by the likes of Dr Williams that the financial services industry is a world entirely unto itself, leeching off the face of humanity, but in fact the great bulk of what it does is provide a service to others. As Mr Tyrie asks, what effect would the tax have on all these innocent users of financial services, for example, manufacturers hedging their foreign exchange risks, or efficient cash management to ensure adequate liquidity in the wider economy?

For heaven's sake, Archbishop, think things through before you jump on the latest fast-buck idea from Europe for feathering the bureaucratic nest.

Paul Krugman and Cameron’s realism

I rarely write about this poor and benighted, yet still free, isle.

But Paul Krugman’s latest attack on the Government’s austerity policy – "Cameron’s Fantasy" – cannot go unchallenged.

He ridicules Cameron’s claim that fiscal discipline has brought down British borrowing costs and averted a debt crisis, more or less depicting him as clueless.

I happen to be a Krugman fan, not least because it is a delight to see a great economic mind at work – in real time, so to speak. He deserved to win the Nobel Prize, and he has been largely right about the shape of our global economic crisis over the last four years.

However, he is wrong about the specific case of Britain.

He displays this chart to show that US bond yields have fallen even further than gilt yields, and to show that they are doing so for deep structural reasons.

It is a false comparison. Britain is not the world’s paramount strategic and reserve currency power. It does not have latitude to trifle with global markets.

(Yes, I know, Japanese, German, Swedish and Danish yields are also falling, but these countries have large current account surpluses. The three Europeans are fiscal saints. Japan is still the world’s top creditor, with nearly $3 trillion in net assets.)

There was a horrible moment in the weeks leading up to the elections last year when it became clear that the vigilantes were indeed waiting to pounce on Britain.

This is a news piece I wrote at the time, citing the Unicredit team, and Unicredit was not alone.

"I am becoming convinced that Great Britain is the next country that is going to be pummelled by investors," said Kornelius Purps, Unicredit's fixed income director.

Mr Purps said the UK had been cushioned at first by low debt levels, but the pace of deterioration has been so extreme that the country can no longer count on market tolerance: "Britain’s AAA-rating is highly at risk. The budget deficit is huge at 13pc of GDP and investors are not happy. There will have to be absolute cuts in public salaries or pay, but nobody is talking about that.

"Sterling is going to fall further over coming months. I am not expecting a crash of the gilts market, but we may see a further rise in spreads of 30 to 50 basis points."

That was the mood in March 2010. The spreads were ballooning out to worrying levels.

Britain has won a reprieve because the Coalition has held rock solid and stuck to its policies. Perhaps there might be some safe margin for loosening now, but not much.

There was of course never any danger of a Greek/Irish/Portuguese outcome, given the Bank of England’s willingness to backstop the system with QE equal to 19pc of GDP).

However there was a risk of yields creeping up to Spanish levels and also something very familiar to Treasury mandarins, a disorderly flight from sterling. (As opposed to the orderly fall we have had, and which has been a lifesaver for parts of manufacturing industry.)

Needless to say, we can never prove this either way.

Britain has rescued itself twice over the last century by a radical mix of fiscal tightening on the one hand and monetary stimulus with devaluation on the other. We did it in 1931-1932 after liberation from the Gold Standard, and we did it again in 1992-1993 after liberation for the Europe’s Exchange Rate Mechanism (when Cameron had a ring-side seat as an aide to Chancellor Norman Lamont).

The trick worked both times. We largely avoided the Great Depression. We outperformed in the 1990s.

One can see why Professor Krugman dislikes this argument. It would question the primacy of Keynesian fiscal policy.

Perhaps fiscal policy is less potent than claimed. Or perhaps there is something specific about Britain, evidence that economics is really a subset of anthropology.

David Cameron is running Britain, not the United States, Germany, or Japan. We are a nation of flat-footed and humble shopkeepers over here. We don’t like theory. We like only realism.

Revenge of the Sovereign Nation

Greek presidential guards perform a change of shift in front of the parliament in Athens (Photo: Reuters)

Greece’s astonishing decision to call a referendum – "a supreme act of democracy and of patriotism", in the words of premier George Papandreou – has more or less killed last week’s EU summit deal.

The markets cannot wait three months to find out the result, and nor is China going to lend much money to the EFSF bail-out fund until this is cleared up. The whole edifice is already at risk of crumbling. Société Générale is down 15pc this morning. The FTSE MIB index in Milan has crashed 7pc. Italian bond spreads have jumped to 450 basis points.

Unless the European Central Bank step in very soon and on a massive scale to shore up Italy, the game is up. We will have a spectacular smash-up.

If handled badly, the disorderly insolvency of the world’s third largest debtor with €1.9 trillion in public debt and nearer €3.5 trillion in total debt would be a much greater event than the fall of Credit Anstalt in 1931. (Let me add that Italy is not fundamentally insolvent. It is only in these straits because it does not have a lender of last resort, a sovereign central bank, or a sovereign currency. The euro structure itself has turned a solvent state into an insolvent state. It is reverse alchemy.)

The Anstalt debacle triggered the European banking collapse, set off tremors in London and New York, and turned recession into depression. Within four months the global financial order had essentially disintegrated.

That is the risk right now as the reality of Europe’s make-up becomes clear.

The Greek referendum – if it is not overtaken by a collapse of the government first – has left officials in Paris, Berlin, and Brussels speechless with rage. The ingratitude of them.

The spokesman of French president Nicolas Sarkozy (himself half Greek, from Thessaloniki) said the move was “irrational and dangerous”. Rainer Brüderle, Bundestag leader of the Free Democrats, said the Greeks appear to be “wriggling out” of a solemn commitment. They face outright bankruptcy, he blustered.

Well yes, but at least the Greeks are stripping away the self-serving claims of the creditor states that their “rescue” loan packages are to “save Greece”.

They are nothing of the sort. Greece has been subjected to the greatest fiscal squeeze ever attempted in a modern industrial state, without any offsetting monetary stimulus or devaluation.

The economy has so far collapsed by 14pc to 16pc since the peak – depending who you ask – and is spiralling downwards at a vertiginous pace.

The debt has exploded under the EU-IMF Troika programme. It is heading for 180pc of GDP by next year. Even under the haircut deal, Greek debt will be 120pc of GDP in 2020 after nine years of depression. That is not cure, it is a punitive sentence.

Every major claim by the inspectors at the outset of the Memorandum has turned out to be untrue. The facts are so far from the truth that it is hard to believe they ever thought it could work. The Greeks were made to suffer IMF austerity without the usual IMF cure. This was done for one purpose only, to buy time for banks and other Club Med states to beef up their defences.

It was not an unreasonable strategy (though a BIG LIE), and might not have failed entirely if the global economy recovered briskly this year and if the ECB had behaved with an ounce of common sense. Instead the ECB choose to tighten.

When the history books are written, I think scholarship will be very harsh on the handful of men running EMU monetary policy over the last three to four years. They are not as bad as the Chicago Fed of 1930 to 1932, but not much better.

So no, like the Spartans, Thebans, and Thespians at the Pass of Thermopylae, the Greeks were sacrificed to buy time for the alliance.

The referendum is a healthy reminder that Europe is a collection of sovereign democracies, tied by treaty law for certain arrangements. It is a union only in name.

Certain architects of EMU calculated that the single currency would itself become the catalyst for a quantum leap in integration that could not be achieved otherwise.

They were warned by the European Commission’s own economists and by the Bundesbank that the undertaking was unworkable without fiscal union, and probably catastrophic if extended to Southern Europe. Yet the ideological view was that any trauma would be a “beneficial crisis”, to be exploited to advance the Project.

This was the Monnet Method of fait accompli and facts on the ground. These great manipulators of Europe’s destiny may yet succeed, but so far the crisis is not been remotely beneficial.

The sovereign nation of Germany has blocked every move to fiscal union, whether Eurobonds, debt-pooling, fiscal transfers, or shared budgets. It has blocked use of the ECB as a genuine central bank. The great Verfassungsgericht has more or less declared the outcome desired by those early EMU conspirators to be illegal and off limits.

And as my old friend Gideon Rachman at the FT writes this morning: the Greek vote is “a hammer blow aimed at the most sensitive spot of the whole European construction – its lacks of popular support and legitimacy.”

Indeed, how many times did we chew this over in the restaurants of Brussels, Stockholm, Copenhagen, Dublin, or the Hague years ago, as one NO followed another every time an EU state dared to hold a referendum.

I think it is fair to say events are unfolding more or less as we expected.

New ECB chief must act as Europe again stares into the abyss

Welcome to Bedlam Mr Draghi. Yes, it's Mario Draghi's first day in the office as the new European Central Bank president, and if he was hoping, after last week's "comprehensive settlement", for a reasonably settled start, he had better think again.

We all know what Mr Draghi should be doing; he should be immediately reversing the last two interest rate increases and at the same time engaging in a much more wide ranging programme of quantitative easing through sovereign bond purchases. Tomorrow, Mr Draghi chairs his first meeting of the governing council. It's his chance to start with a bang.

Yet despite the renewed turmoil sparked by the Greek referendum announcement, it seems quite unlikely he'll take it. By temperament, he's quite orthodox in his approach to central banking, and the fact that he is an Italian will, paradoxically, make him even keener to stick to conventional monetary disciplines than if he were an Axel Weber-like, anti-inflationary head banger. He'll want to disprove the Italian steriotype. And he's terrified of doing anything that might upset Bundesbank traditionalists. So there is no reason to believe his arrival will presage an immediate change in approach after the "strong vigilance" of his predecessor, Jean-Claude Trichet.

That's not to say we won't see a cut in interest rates. The last meeting was split in leaving rates on hold, so with a fast deteriorating economy, it's possible the doves will this time gain the upper hand. Eurozone inflation at 3pc is beyond what would normally be regarded as tolerable, but everyone knows that on a medium term view, the inflation rate is going to fall well below the 2 per cent target. So a rate cut can easily be justified.

But I'd be amazed if we saw anything new on bond purchases. The ECB doesn't regard it as any part of its job to monetise the public debts of the eurozone periphery. Of course, there is a fair amount of pretence in this stance.

The ECB has already done quite a bit of bond buying, which it has disingenuously dressed up as a way of helping the "monetary transmission system". The sophistry of this explanation is ridiculous. No, what the ECB has been doing is trying to drive bond yields in the distressed single currency nations down to more tolerable levels.

Even so, the numbers have been very low against what the Federal Reserve has been doing in the US, and the Bank of England in the UK. As long as Germans believe that bond buying by the central bank is essentially monetisation of public debt – the sort of stuff that led to the Weimar hyperinflation of legend – it will be blocked from meaningful action.

Mr Draghi's challenge is therefore to persuade Berlin that bond purchases are for a different purpose – demand management. This is essentially the justification that underpins QE in Britain and the US. In both cases, the intention is eventually to sell the accumulated bond holdings back to markets, or to run down the positions by allowing the bonds to mature.

To better support this justification, ECB bond purchases would have to be much more widely spread than at present. It would have to include German bunds in proportion to the size of the German economy alongside Italian, Spanish and Portugese debt. But as I say, Mr Draghi faces an uphill struggle. Germans would prefer to suffer, or even see the euro collapse completely, than tolerate such an unconventional approach.

Greece must vote no to the bailout terms

Eurozone policymakers will view with horror George Papandreou's decision to hold a referendum on the Greek bailout package. Less than a week after agreeing a "comprehensive" deal to resolve Europe's sovereign debt crisis, the whole thing already seems to be coming apart at the seams. The Greek prime minister's commitment to a plebiscite introduces a further element of extreme uncertainty.

But for everyone, it could also be a blessing in disguise, for a vote on the bailout package would also in effect be a vote on continued membership of the euro. If it went against Mr Papandreou, his government would fall, and given that Greece could no longer deliver on the conditions attached to the bailout, public money to pay wages, pensions and bills would soon run out. The country would descend into chaos.

To restore order, whoever stepped into the ensuing vacuum would have to impose capital controls and leave the euro. It would be a cataclysmic economic event, but very probably better than the death by a thousand cuts that awaits if Greece agrees the bailout. The sudden death of a no vote is what Mr Papandreou will use as his chief weapon in presenting the case for acceptance of the bailout terms. But it is by no means clear he is going to win.

Things are about to get really interesting.

Italy, Europe, and Red Brigade terror

Matters are turning serious.

Italy’s labour minister Maurizio Sacconi has just warned that a rushed shake-up of the labour market – as demanded by the EU – risks setting off a fresh cycle of terrorism in the country.

Here is the story from Il Sole.

“We must stop creating tension over labour reform which could lead to a new wave of attacks. I am not afraid for myself because I have (armed) protection. I am afraid for the people who are not protected and could become a target of political violence that is not extinct in our country,” he said.

This is not exaggeration. The Red Brigades-PCC assassinated Massimo D’Antonna in 1999 and Professor Marco Biagio in 2002 for spear-heading labour reforms.

Opposition leader Pier Luigi Bersani praised Mr Sacconi for speaking out at last. “We are in deep trouble. If we ignite the powder-keg of social discord instead of cohesion we will do dramatic damage to the country.”

The EU has woven itself into this drama by presenting Italy with an ultimatum last week, giving the country barely 48 hours to commit to very specific and radical reforms. It is in effect taking sides in an intensely polarized debate within Italy. It is intruding in the most sensitive matters of how society organizes itself, in effect demanding ideological changes – in this case in favour of employers, and against unions – as a condition for further action to shore up Italy’s bond markets.

"We have three deaths in front of us: democracy, politics, and the Left," said Fausto Bertinotti, the elder statesman of Rifondazione Communista and one of Italy's great post-war figures.

"We are living in a neo-Bonapartist financial system. Not a single decision has been taken by the Italian parliament since the end of August except those imposed by the foreign power that now us under administration."

The two bones of contention are Article 18 protecting workers from being sacked for economic reasons, and “firm level agreements” that undercut the power of trade unions to craft deals across sectors.

Those of us in Anglo-Saxon cultures may find it remarkable that Italy still has laws that make it extremely hard for companies to lay off workers when needed. It is clearly a reason why the country has struggled to adapt to the challenge of China, rising Asia, and Eastern Europe.

But that is not the point.

Are such changes to be decided by Italy’s elected parliament by proper process, or be pushed through by foreign dictate when the country is on its knees? “Political ownership” is of critical importance. The EU is crossing lines everywhere, forgetting that it remains no more than a treaty organization of sovereign states. Democratic accountability is breaking down.

This is dangerous. It is only a question of time before the EU itself becomes the target of terrorist attacks in a string of countries, and then what? Will the Project start to demand coercive powers? Will it acquire them?

Eurosceptics have been vindicated. They warned from the start that EMU was a dysfunctional under-taking and that in order to stop it leading to calamitous failure, there would have to be ever deeper intrusions into the affairs of each state and society.

This is now happening at a galloping pace. We really will end up an authoritarian supra-national octopus if this goes on much longer.

Europe kowtows to the Chinese dragon

Come to this. Few things could be more bizarre, or humiliating, than the sight of eurozone political leaders kowtowing to the Chinese in the hope that a few crumbs might fall from the dragon's table to help prop up the newly enhanced European Financial Stability Facility.

The Chinese threaten to extract a high price; security for their money, open access to European markets and freedom to buy advanced technologies (and there I was thinking they'd already stolen it all). They might also demand, though I have seen no evidence for this in published comments, that Europeans cease all open criticism of Chinese mercantalism, human rights abuse and anything else that tends to concern us over China's ever onwards and upwards rise to superpower status.

A few facts and figures. At $12.2 trillion in 2010, the eurozone's gross domestic product is more than twice as big as that of China and its income per capita is more than four times as high. And yet there's the eurozone's emissory, Klaus Regling, going cap in hand begging for handouts. How can a region be so rich and yet apparently so poor at the time?

It's a paradox which goes to the heart of the problem of global imbalances. What in effect is happening is that the Chinese earn far more than they spend. The consequent surplus in earnings and production is saved and exported. It's a funny old world that has some of the poorest people in the world lending to some of the richest to buy the goods they make but cannot themselves afford to buy, but that's the way it is.

Whatever concessions the Chinese manage to extract from the likes of Nicolas Sarkozy, who's been on the phone to President Hu Jintao, they would be well advised to leave well alone. As the investment guru Jim Rogers said on BBC radio's Today programme, the EFSF is essentially a scam. It might buy a little time, but it cannot solve the eurozone's underlying problems. The bit of it the Europeans want the Chinese to invest in is a "special purpose vehicle" – appropriately known as a SPIV – which is essentially a piece of financial engineering to make the fund bigger than it really is. It's a confidence trick.

It's also a surrogate for what the eurozone should really be doing to add liquidity to distressed peripheral nation bond markets – which is to give the European Central Bank the freedom to act as a central bank is meant to in its lender of last resort capacity and print money to ease the crisis (see this excellent piece by the economist Paul De Grauwe). Only the Germans won't allow it. They'd prefer to dance with the Chinese dragon than do the obvious. At best, they are going to end up badly singed.

Europe’s Punishment Union

Herman Van Rompuy at the end of the summit (Photo: EPA)

Very quickly, there has been much loose talk about EU fiscal union. What was agreed at 4AM this morning is nothing of the sort.

It is a "Stability Union", as Angel Merkel stated in her Bundestag speech. Chalk and cheese.

"Deeper economic integration" is for one purpose only, to "police" budgets and punish sinners.

It is about "rigorous surveillance" (point 24 of the statement) and "discipline" (25), laws enforcing "balanced budgets" (26), and prior vetting of budgets by EU police before elected parliaments have voted (26).

This certainly makes sense if you want to run a half-baked currency union. As the statement says, EMU’s leaders have learned the lesson of a decade of self-delusion. "Today no government can afford to underestimate the possible impact of public debts or housing bubbles in another eurozone country on its own economy."

But none of this is fiscal union. There is no joint bond issuance, no move to an EU treasury, no joint budgets with shared taxation and spending, no debt pooling, and no system of permanent fiscal transfers. Nor can there be without breaching a specific prohibition by Germany's top court, a prohibition that could be overcome only by changing the Grundgesetz and holding a referendum.

(Yes, you could argue that leveraging the EFSF bail-out fund to €1 trillion with "first loss" insurance of Club Med debt implies a massive German-Dutch-Austrian-Finnish-Estonian-Slovak transfer one day to the South. But again, is that really a fiscal union? Mrs Merkel says this money will never be needed because the mere pledge will restore market confidence.)

As Sir John Major wrote this morning in the FT, this does not solve EMU’s fundamental problem, which is the 30pc gap in competitiveness between North and South, and Germany’s colossal intra-EMU trade surplus at the expense of Club Med deficit states.

It is therefore unlikely to succeed. It means that Italy, Spain, Portugal, et al must close the gap with Germany by austerity alone, risking a Fisherite debt deflation spiral. As I have written many times, this is a destructive and intellectually incoherent policy, akin to the 1930s Gold Standard. It risks conjuring the very demons that Mrs Merkel warns against.

Sir John is less categorical, but the message is the same. Europe will have to evolve into a fiscal union to make the system work, but that would be inherently undemocratic without a genuine European government, parliament, and civic union. Such a supra-national union cannot enjoy democratic vitality because there is no European demos, or shared view of the world, or indeed any popular support for such a revolutionary step. Such a union would castrate historic national parliaments, to the advantage of whom?

So this "solution" leads ineluctably to an authoritarian regime. Bad situation.

The alternative is to break monetary union into viable parts, preferably with the withdrawal of greater Germania from the euro. This is off the table.

So, EMU break-up is Verboten, fiscal union is Verboten, full mobilization of the ECB – either to lift the South off the reefs through reflation, or to back-stop the system as a lender-of-last resort – is Verboten. Germany will have none of it.

Instead we have the summit conclusions – EUCO 116/11 of October 27 2011 – and a great deal of coercion.

Please tell me what exactly has been solved.

Why the summit to end all summits solves nothing

Angela Merkel at the Justus Lipsius building in Brussels (Photo: AFP/Getty)

Will the grand plan cobbled together by eurozone leaders in the early hours of Thursday morning work in saving the euro? As Sir Mervyn King, Governor of the Bank of England, remarked before it had been signed, it might buy a little time, but it is no kind of long-term solution.

Before explaining why, let's first pick some holes in the plan itself, which amounts to pretty much a clean sweep for the German view on how to proceed and poses almost as many questions as it answers. The only bit which is done and dusted is the banking recapitalisations, where 70 banks have been stress tested and some very precise numbers have been put on the required additional capital.

The overall impact of the banking package is none the less somewhat underwhelming. The stress tests are widely thought wanting by many market participants and the additional capital therefore inadequate. BNP Paribas for one should be able to achieve its €2bn through earnings retention alone. The tests seem once again to have been designed so as to bring about the least possible commitment of new public money rather than once and for all to underpin banking solvency.

Furthermore, the statement seems to imply enforced bail-ins of subordinated debt holders before sovereign support is tapped. This is only going to further unnerve debt holders and will likely further enhance the difficulties many eurozone banks face in accessing wholesale market funding.

On Greece, nothing is done and dusted at all. The suggested 50pc haircut amounts to no more than a statement of intent. Persuading private creditors to accept such a write-off voluntarily will remain an uphill struggle. Many of the banks with big holdings of Greek sovereign debt have hedged themselves against default through CDS contracts. They thus have a positive incentive not to agree the haircut and instead force a "credit event". Only in these circumstances can they claim compensation through the CDS contracts.

There is a sense in which they are damned if they do and damned if they don't. If they agree the haircut, they lose the full amount and cannot reclaim it through the CDS. Yet if they trigger the CDS, they create market mayhem and may therefore end up even worse off. Nobody knows for sure what an uncontrolled default would do, but given the experience of Lehman Brothers, it is perhaps best not to try and find out.

A voluntary deal on the other hand in effect amounts to a breach of the CDS contract. In such circumstances all CDS insurance on sovereign debt essentially becomes worthless. Either way, someone, somewhere is going to lose a lot of money.

But the main strictures must be reserved for the European Financial Stability Facility, the main eurozone bailout fund. Here's what this morning's euro summit statement said about it.

We agree on two basic options to leverage the resources of the EFSF: • providing credit enhancement to new debt issued by Member States, thus reducing the funding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market; • maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets.

This is fine as far as it goes, but as the statement makes plain, investors will be required to pay for the insurance option. It's not clear, given what's just about to happen to CDS contracts on sovereign debt, that they will be willing to do this. What markets now aptly refer to as the "SPIV" option looks a little more promising, but even if it works in leveraging the fund to the €1 trillion policymakers are looking for, it will still fall short. This is what the economics team at Royal Bank of Scotland had to say about it this morning.

To put this number in perspective, if EFSF 3 was to continue buying Italian and Spanish bonds at the same pace as that of the ECB, this would give only 2 years of purchasing power, assuming no other country would require help from the EFSF.

Precisely so. It's nowhere near enough. And this really goes to the heart of the problem. The EFSF is no more than a fig leaf, a wholly inadequate alternative to the European Central Bank, which is precluded from providing the limitless liquidity which would undoubtedly do the job by the German veto.

Think of it like this. In countries such as the UK with their own sovereign currencies, there are certainly risks attached to buying public debt, but default risk is not one of them, since in extremis the central bank can always print the money to redeem the debt at maturity. The default risk only materialises if the sovereign starts raising debt in a foreign currency. In such circumstances, it cannot print money to pay it back.

That's the situation the eurozone periphery nations find themselves in. They have effectively borrowed money in a foreign currency – the euro. Now of course it wouldn't be a problem if the ECB were able to buy the debt without limit, as effectively the central banks of the US and the UK have been.

But scorched by the memory of Weimar, Germany will not allow any such nonsense. The ECB is expected to be the keeper of the Bundesbank tradition in maintaining sound money. It's all very admirable on one level, but it's the wrong policy for a liquidity crisis. There are risks in sanctioning the ECB to let rip with massive QE – moral hazard, inflation and possibly catastrophic balance sheet loss – but it's the only way the eurozone will ever finally lance this sovereign liquidity/solvency problem. Unfortunately, Germany is too stuck in its ways to allow it. Instead, we have the wholly inadequate alternative of the EFSF.

Nor does any of this address the underlying problem of widely divergent competitiveness between the eurozone core and its periphery nations. The sort of governance, structural and budgetary reforms suggested by the statement – including, astonishingly, the creation of yet another European President to manage the affairs of the eurozone – will take years if not decades to make inroads into these imbalances, and that's making the heroic assumption that they are infact implemented. Again Germany is the only country in any position to solve the problem. If it were massively to reflate its own economy, that would help. The chances of this happening are zero.

Big things have been agreed overnight, but policymakers remain in a state of intellectual denial. On the present policy mix, the euro cannot survive.

Avoiding triggering Greek sovereign CDS is a mistake

Should policymakers attempt to prevent credit default swaps?

Credit default swaps (CDS) are supposed to serve as a form of insurance against default.  A sovereign CDS provides insurance against a country defaulting.  If such insurance is not available, then companies and investors, wishing to insure themselves against the possibility of a country defaulting, will either have to reduce their exposure to such an event (eg by selling their holdings of that country’s bonds) or hedge in some other way (eg by going short on that country’s bonds).

In the run-up to the 21 per cent Greek default announced on July 21st, Eurozone policymakers were quite explicit that they would try to design the default in such a way that credit default swaps would not be triggered.  They doubtless thought this a clever wheeze, imagining it would punish those who had used CDS to speculate upon the possibility that Greece would default (how wicked of them!) and might deter others from using CDS to speculate upon Portugal or Italy defaulting.

Of course, one immediate consequence of this was that investors sold their Greek CDS.  But once the July 21st deal was announced, there were consequences for Italy, also.  Italian bond yields spiked.  Partly this was because selling Italian bonds became the key way of speculating upon total collapse of the euro.  And partly it was because if firms and investors wanted to hedge against / speculate about Italian default, they could no longer trust Italian sovereign CDS.  Net Portuguese CDS positions have fallen more than 30 per cent in recent months, and Italian net positions more than 25 per cent, despite increased perceived risk that these countries will default.  As a predictable consequence, Italian bond yields went above 6 per cent.

Following last night’s quasi-deal, the whole concept of a sovereign CDS in the Eurozone appears to be finished.  If losing even 50 per cent of your money on Greek government bonds doesn’t trigger payout on the CDS insurance you purchased, what is the point of them?  Eurozone sovereign CDS are now virtually worthless.

The question now is, once the halo of the EFSF leverage is gone, what are the implications of the death of the sovereign CDS market for Italian bond yields?  Had the larger Greek default triggered CDS payouts, one might reasonably have expected Italian bond yields to fall (at least once the initial dust had cleared), because the credibility of insurance was greater.  But what now?  Had everyone already assumed that Italian and Portuguese sovereign CDS were worthless, or were there some poor souls still hoping they might provide some protection?  If the latter, then we should expect Italian and Portuguese yields to rise (eventually), as a consequence – at least until financial markets can produce some new credible mechanism for providing insurance.

We can observe a paradox here.  In this financial crisis, governments have insisted upon destroying the functioning of capitalism by providing implicit state insurance of banks, through bailouts and debt guarantees.  At the same time, governments have sought to destroy the system of market insurance of banks (and others) that existed through the private sector – through sovereign CDS.  Dumb?  You might very well say that…

Thank you Germany

Angela Merkel glowers at the Bundestag today (Photo: Reuters)

Alone among EU leaders, Chancellor Angela Merkel goes to tonight’s summit in Brussels with an iron-clad mandate. It is a remarkable moment. Never before – to my knowledge – has a national parliament demanded and held a prior vote on an EU summit accord.

Had this principle been established a long time ago, we might have avoided much of the relentless Treaty creep and EU aggrandizement advanced by secret deals at the Bâtiment Justus Lipsius. Thank you Germany.

Thank you too, judges of the Verfassungsgericht, for giving the Bundestag a veto on EU encroachments on fiscal sovereignty. The court is seemingly the only tribunal willing and able to defend the liberties of European citizens against EU over-reach, and is therefore my supreme court too even as a British citizen.

Dr Merkel has won her vote. She secured an "own majority" for proposals to leverage the €440bn bail-out fund (EFSF) into the stratosphere, with the support of some very sheepish looking law-makers from posturing Free Democrats and Bavaria’s Social Christians.

But what a price she paid. The credibility of her team is shattered. Europe has all but destroyed her, even if she manages to limp on to the next crisis.

As she glowered darkly, speaker after speaker from the Social Democrats (SPD), the Greens, and Die Linke, asked how she could possibly reconcile her plan to leverage the EFSF to €1 trillion or €1.5 trillion (we still don’t know how much) with solemn pledges to the Bundestag just three weeks ago that there would be no such leverage.

"Shameless abuse of the truth," was the verdict of SPD leader Frank-Walter Steinmeier. The government had acted "tactically" at every turn, "misled the people", "held back information", "crossed every red line", brought Europe "to its knees" with botched policies, and lied blatantly about EFSF leverage.

"You came here to say there would be no leverage, not three years ago, not three months ago, but three weeks ago. You denied everything."

"This is a matter of democracy in our country. Trust is the resource with which we all work." (For those German speakers who watched the debate, excuse my instant and loose translation, but I think it is not far off.)

Die Linke (Left) leader Gregor Gysi was electrifying. "It is the arrogance of power," he began, and never let go.

"Every week you come up with a different story about this crisis."

"We were told there would be no leverage and you have reversed everything in a matter of weeks. Now we learn that the 20pc loss will fall entirely on taxpayers. They alone will pay. That is the decision you are taking."

"Why don’t you tell German taxpayers the truth? They are being asked to pay the losses for French banks."

Green leader Jürgen Trittin rebuked Dr Merkel for hiding the true implications of EFSF leverage, particularly the plan to insure the first 20pc of losses on Club Med bonds.

"Why are you shying away from telling the people the truth? You must tell people what this leverage means. You must explain to them what the risk is, and why it is necessary. But you wriggled out of it."

"You came here three weeks ago and said there would be no leverage. This is the sort of thing that unnerves people."

And so it went on, raw red-blooded democracy.

The unpleasant truth is that the EFSF leverage proposals are idiotic, the worst sort of financial engineering, legerdemain, and trickery.

As countless economists have pointed out, it concentrates risk. Germany’s €211bn commitment to the fund is not technically breached but the risk of suffering large and perhaps total loss is vastly increased. Creditor states switch from protected senior status on Greek, Portuguese, or Italian debt to the bottom rung on new slabs of sub-prime structured credit. The bluff might well be called.

The consequence will be to bring forward the downgrade of France and other states. It will accelerate contagion to the core, not stop it.

Why is Germany pushing for such a destructive policy? Because it dares not cross the €211bn red-line that has become totemic in the Bundestag, and because it has for ideological and cultural reasons excluded the one option that can plausibly halt the eurozone crisis – which is mobilizing the full fire-power of the European Central Bank.

It should be obvious by now that euroland needs an authentic lender-of-last-resort. Yes, there is a risk that ECB bond purchases could degenerate into chronic monetisation of deficits. But it is an even greater risk that the EFSF – as proposed – will set off a calamitous chain of events.

Personally, I felt almost swept along by Chancellor Merkel as she pleaded for support to help put Greece "back on its feet again", etc, etc, and warned with pathos that another fifty years of peace in Europe cannot be taken for granted.

But as soon as you think about it, such a claim to idealism is make-believe. Her own government is the architect and enforcer of one-sided austerity policies – without offsetting monetary and exchange stimulus, or demand growth in the North – that are pushing Southern Europe into debt deflation and a downward economic spiral.

It is her own call for bondholder haircuts in Greece that set off contagion from Greece, first to Ireland and Portugal, and then to Italy and Spain. It is her refusal to contemplate a change in the mandate of the ECB – by treaty if necessary – that is now exacerbating the crisis.

Far from preserving the peace of Europe for another fifty years, her policies are more likely to bring about the very mischief and grief she warns against.

So let us take her Rhetorik with a pinch of salt.

Still, a splendid day for German democracy.

Inflation Out of Sight

Since the Great Recession began in December 2007, the overall consumer price index is up 7.5 percent, or 1.9 percent a year. But there are plenty of people who insist that the figure must understate actual inflation, citing their own impressions from visits to stores.

In researching my Off the Charts column for this week, which looks at trends in apparel prices, I came across two categories that have been moving in opposite directions, for no reason I could discern. In one, inflation appears to be out of control. In the other there is deflation.

The government puts out a little-noted series on department store inventory prices. It covers goods sold in department stores, but includes prices from other stores. So prices charged at Wal-Mart and the Gap presumably count. It is not just a measure of what Macy’s and Nordstrom are charging.

Such prices can be volatile (SALE! SALE!), so the chart following uses three-month moving averages of seasonally adjusted prices, and shows changes from the level in the three months ended in December 2007.

Prices of a category called Women’s Outerwear and Girls’ Wear are down 4.8 percent, although that index has begun to rise recently. Other than shoes, that category includes most everything women wear that is supposed to be visible, including coats, dresses, skirts, pants and blouses.

Then there is the category Women’s Underwear, which by the way does not include stockings. It is up 32.5 percent, an annual rate of 7.8 percent.

What is going on? Cotton prices went up, as Stephanie Clifford reported a year ago. But cotton prices are lower now than they were then, and the underwear index is higher.

Would anyone care to explain why, as the economy went down, the prices of undergarments went up?

There is, alas, no separate category for men’s underwear.

Sedan again as Germany imposes terms

Bismarck conversing with Napoleon III after the Battle of Sedan, 1870

German victory. Defeat for France, Spain, Italy, and the Greco-Latin sphere.

My instant impression from the leaked EU summit draft - obtained by our indefatigable Brussels correspondent Bruno Waterfield – is that the accord is minimalist, and largely a German Diktat. It has the makings of a diplomatic Sedan 1870.

If this is what landed on Nicolas Sarkozy’s desk at the Elysee yesterday, one starts to grasp, sort of, why he left Carla Bruni to labour alone as he dashed to Frankfurt to meet the two other women in his life, Chancellor Angela Merkel and IMF chief Christine Lagarde, as well as the European Central Bank’s old and new chiefs.

This document is not final, of course. Mr Sarkozy knows how go full-throttle histrionic, throw a fit, play the war guilt card, scream, shout, and even threaten to walk out of Emu (as he did in the May 2010 summit). He is so mercurial and impetuous that he might actually do something shocking if Germany refuses to meet him half way.

The text may well be very different by Sunday. It had better be.

1) There will be no change to the mandate or role of the ECB. The doctrine of "Price Stability" is upheld. (That is not the historic role of central banks, by the way. They were created in the 17th century to be lenders of last resort, as was the Fed before World War One. The idea that their chief task is to manipulate a single variable – the price level – is both new and misguided.)

There is no hint that the full firepower of the ECB will be harnessed to solve this crisis, as demanded by France, the US Treasury, the IMF, and much of the City. In my view this refusal to deploy the ECB is a colossal error, and will doom the summit outcome to failure.

2) There will be no move to fiscal union in the way we all understand it: no eurobonds, fiscal pooling, no big transfers. Zilch, as expected.

The so-called "Six Pack" of proposals for closer EU economic government relate to the policing of budgets, and such like. They are a means of imposing austerity, not sharing debts. This is what Germany means by "Fiskalunion". It is a loss of sovereignty for one purpose only.

The deflationary bias of the EMU system remains in place.

3) The permanent bail-out fund (ESM) will be brought forward from June 2013, but there is no date. The purpose of this trick is to allow the existing €440bn EFSF and ESM to operate at the same time, giving the rescue machinery greater fire power. OK, but rating agencies might notice. So will investors. Surely double-edged?

4) 5) 6) are kicked into touch until finance ministers gather on Friday. These cover the leverage of the EFSF, the scale of haircut for Greek bondholders, and the scale of bank recapitalization ( apparently now just €80bn, which is not going to do the trick).

There is an "unequivocal commitment" that haircuts will be confined to Greece alone. If you believe that, I have some ocean-front property to sell you in Alsace.

Fresh details soon.