Just as Greek politicians got on track to install a “technocratic” government that would agree to implement the additional austerity measures required to access additional bailout money, Italy’s inability to do the same has once again roiled markets. Even though tainted Prime Minister Berlusconi has said he’d step down once the parliament passes a restrictive budget, the always-chaotic state of Italian politics obscures the way forward. We don’t know when – or even if – such a budget will pass, how much it will effectively reduce Italy’s need to borrow if it does pass, or if any near-term stringency imposed by that budget will further weaken Italy’s already stumbling economy. What’s more, unlike the situation in Greece, where the two major parties have agreed that someone who’s above politics (whatever that can possibly mean) should run the government, no names mentioned to date have the credibility to replace Berlusconi. Therefore, as new elections become more likely, the policy outcome becomes harder to forecast.

Ok…that’s politics, but today’s most significant new development is somewhat more arcane. Have you ever heard of London Clearing House.Clearnet SA? Unless you work in the settlements department of a bond trading firm, you probably haven’t. LCH is a clearing house that guarantees you’ll get paid if you sell a security—like an Italian government bond. Today, LCH raised the deposit (or collateral) required to trade Italian government bonds, thereby making them more expensive to hold and trade. This means that banks that own Italian bonds are less well capitalized today than they were yesterday. I believe the result will be higher borrowing costs for banks, less liquidity in the financial system, and a heightened threat of financial paralysis, à la 2008. Let me stress, however, that this is not yet a Lehman moment. Although market measures of stress in the European banking system—such as inter-bank lending rates—are at levels not seen since the first quarter of 2009, they are well below peak 2008 meltdown levels.

As a monetarist (I’m a student of the “Chicago school” of economics), I believe that when banking shrinks, the money supply shrinks, and when the money supply shrinks, economies shrink. I believe that’s what the Great Depression was all about, and that’s what our own Great Recession was all about. If Europe is to avoid another “great contraction,” it will not only need a ready supply of money, but for the market to believe that the supply of money is effectively limitless. Who can supply that money? The European Central Bank (ECB), of course. So far, however, in keeping with its anti-inflation mandate and ideology, the ECB has refused to purchase additional bonds to spike the money supply. Europe is approaching the need for a credible lender of last resort. Someone should tell the ECB that it’s 2011, not 1923.

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