PARIS The European Central Bank waved its big fire hose at blazing bond markets, then turned on a puny sprinkler.
Unsurprisingly, the fire refused to go out. Indeed, the flames grew higher, licking the feet of Italy and Spain, the currency area's third and fourth largest economies.
Three days later, the bank's governing council decided in an emergency Sunday night conference call to change course abruptly and resort to the big fire hose after all.
The ECB may now become the reluctant owner of tens of billions of euros in Italian and Spanish debt in a high-risk strategy to avert a European financial meltdown.
It wasn't the first time since the euro zone's sovereign debt woes began in late 2009 that the guardians of Europe's single currency had been forced by events into a U-turn.
The hesitant response to the latest and most dangerous turn in the crisis illustrates how political constraints are making it ever harder for Europe to find effective solutions.
The 17-nation euro area lacks a lender of last resort, and its politicians and central bankers continue to argue over who, if anyone, should play that role.
European leaders thought they had erected a firewall at a July 21 emergency summit by agreeing on a second bailout for Greece, the weakest link in the euro chain, and approving new steps to prevent contagion to other countries.
Yet after a 24-hour relief rally, investors gave the complex deal the thumbs-down, judging it insufficient to stop the rot, and spying a window of vulnerability before the measures took effect.
Faced with a massive selloff of Italian and Spanish debt that was forcing those countries' borrowing costs up towards unsustainable levels, the ECB decided last Thursday to buy small amounts of Irish and Portuguese bonds only.
"What would we make of a fire brigade that responds to a major emergency but then drives to the wrong place and refuses to turn around and douse the real fire?" asked economist Holger Schmieding of Germany's Berenberg Bank.
There were three possible reasons for the strange decision, which ECB president Jean-Claude Trichet communicated without his usual assurance:
- a dissenting minority on the bank's governing council opposed to any bond-buying has grown from one last year to four of the 23 members last week, ECB sources say;
- most ECB policymakers thought Italy needed to do much more to put its public finances in order and liberalise its sclerotic economy before it deserved any support;
- and anyway, the ECB wanted euro zone governments to take over the burden of buying risky bonds with their own rescue fund, which ECB sources say central bankers believe should be at least doubled in size to fit the purpose.
By deciding on a half-measure, the ECB deliberately or accidentally heightened bond market pressure on Rome and Madrid. The downgrading the United States' credit rating last Friday did the rest.
Without decisive action by the central bank, the euro zone crisis was set to spiral out of control on Monday morning, EU officials agreed in frantic weekend telephone consultations.
Under fierce pressure from his European peers, Italian Prime Minister Silvio Berlusconi agreed hastily on Friday to bring forward budget balancing measures by a year to 2013.
He also pledged to anchor a balanced budget rule in the constitution and to push through long-deferred reforms of the welfare system and labour markets after talks with trade unions and employers.
Seasoned Italy-watchers are sceptical of such vague promises by a shaky government to "fast-track" reforms through a fractious parliament, where Berlusconi's authority is waning as he stands trial for alleged fraud and sex with a minor.
Some central bankers hoped that leaving Italy to twist in the wind a bit longer at the mercy of bond market vigilantes would concentrate minds in Rome on finally breaking the habits of a lifetime.
That was before Standard & Poor's lobbed a hand grenade into the markets by downgrading the United States' AAA credit rating to AA+ with a negative outlook on Friday, sending perhaps the strongest tremors around the global financial system since the 2008 collapse of Lehman Brothers.
The ECB has now been forced into a major commitment, which it insists is temporary, to buy Italian and Spanish bonds to try to stabilise markets.
Euro zone leaders agreed last month to allow their 440-billion-euro European Financial Stability Facility to buy bonds on the secondary market under strict conditions and to give precautionary loans to countries in difficulty.
But those new powers won't apply until national parliaments approve the changes, probably in late September. Moreover, the two leading euro zone nations, Germany and France, don't want to increase the EFSF's size out of concern for their own finances.
To ease the ECB's policy shift, German Chancellor Angela Merkel and French President Nicolas Sarkozy promised that the EFSF would take on responsibility for bond-buying in the secondary market as soon as its new powers were in force.
But markets may not be convinced that either institution has the political stamina and the financial fire-power to shield Italy durably from danger unless it achieves an improbable twin
conversion to fiscal discipline and economic growth.
Critics say past ECB bond-buying has had only temporary calming effects and did not prevent Greece, Ireland or Portugal from requiring bailouts.
"Over time, we believe that ongoing selling pressure will force the ECB/EFSF to eventually hold close to half of the traded Italian and Spanish debt or around 850 billion euros," economists at RBS bank said in a research note.
Such a huge holding of southern countries' debt could amount to a de facto mutualisation of euro zone debt risk, potentially heightening a political backlash in northern Europe.
Even if the fire subsides for now, prepare for more blazes.
(Editing by Michael Roddy)