By Matthew Lynn

WASHINGTON (MarketWatch) — Italy is wobbling. Spain is facing a fresh crisis. Even France doesn’t look like it is a secure member of the euro zone anymore. The storms swirling around Europe’s beleaguered single currency are growing by the day as the crisis moves in from the periphery into what can only be regarded as core Europe. The markets remain poised on a knife edge, fearful of the consequences of a full scale collapse.

And yet, the one thing that can’t be underestimated is the political will of Europe’s leaders to keep the euro alive. Three generations of politicians have staked their careers on closer European integration. They won’t give up without a fight.

They will make one last-ditch effort to save the project. How? Europe will soon start printing money on a massive scale — far larger than even the U.S. Federal Reserve’s exercises in quantitative easing.

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That is the only move that can save the euro. And when it happens, it will spark another rally in global commodity and asset prices.

By training their guns on Italy, the bond markets have taken the euro zone’s debt crisis up to a new and far more dangerous level. Italy is a big, important economy. It has the third largest debt market in the world after the U.S. and Japan. And even though the Italians save a lot by global standards, and buy their own government’s debt, even the hard-working citizens of Milan and Turin can’t absorb all the paper the Italian government has issued over the years. Around half of that debt is internationally traded. If the country goes to the brink of insolvency, the shock waves will be felt everywhere.

Italy cannot be ignored. But it increasingly looks as if it can’t be bailed out either.

European Union leaders are meeting on Thursday for yet another summit. The aim, as always, will be to convince the markets that this time they have really got a grip on the crisis. And, as so often during the year this crisis has been dragging on, they won’t be able to agree on a plan that convinces anyone they can stop the contagion spreading.

The reason is simple. They can’t get a grip because they keep getting offered completely unacceptable choices.

Realistically, there are only two ways out of this mess. A fiscal union that involves massive transfers from Germany to the peripheral countries — and quite possibly to Spain and Italy as well. Or else a managed default and an exit from the euro by Greece, Portugal, and potentially some other countries as well.

The trouble is, neither is politically feasible. The German electorate won’t accept paying vast subsidies to the periphery. They are already up in arms about paying for the Greeks. Present them with the bill for Italy, and the German Chancellor Angela Merkel can kiss goodbye to any hope of re-election.

And yet, the EU’s establishment can’t contemplate default or the break-up of the single currency either. For 60 years, the momentum of the EU has been toward ever closer union. The euro was a key step in that process. If it starts to break apart, the momentum will swing into reverse. If countries can opt out of the euro, why not start opting out of any other part of the EU that isn’t working for them? Very soon, the whole structure will start falling apart.

Neither is acceptable. So what do you do? Simple logic tells us they will scrabble around for a third option.

In fact, there is one available. A massive QE blitz. The European Central Bank can simply print money and monetize the debt by buying up the bonds of the peripheral countries. That will achieve two things. It will finance those governments that can no longer borrow from the markets. And, because foreign exchange dealers hate to see money being printed, it will drive down the euro, making it easier for the continent to export its way out of trouble.

It might not make sense in the long-run. But, hey, it will hardly be the first time politicians have put short-term survival ahead of the long-term interests of their country or continent. Likewise, the ECB will resist. But the bank has a new president, Italian Mario Draghi, taking charge after the summer, and he is more likely to buckle under the huge political pressure to start buying government bonds directly than his predecessor was.

How much money are we talking about? The Royal Bank of Scotland estimates that at least 2 trillion euros may needed to be added to the emergency funds set up by the EU to keep the single currency afloat. True, that money could be borrowed from the wealthier members, but the more likely outcome is that it is simply printed. Even that may ultimately turn out to be relatively conservative figure.

Let’s put that in perspective. The Federal Reserve’s first round of QE was $1.25 trillion, and the second round was $600 billion. Two trillion euros is $2.8 trillion. So the total program could be half as much again the entire Fed stimulus package. In other words, the amount of money printed to prop up the euro is going to far larger than anything we have yet seen.

That is going to have a huge impact right around the world. When Japan started QE in the 2000s, it buoyed asset prices elsewhere through the “carry trade.” Investors borrowed cheap yen, and bought assets elsewhere. When the Fed embarked on QE, stocks and commodity prices rose sharply.

It won’t be any different when the ECB takes its turn. Indeed, one of the curious features of QE programs is that they lift asset prices — but not necessarily in the country that prints the money. In fact, they have a tendency to rise most outside the home country.

So global asset prices can expect another lift from the ECB’s blitz. It might — indeed almost certainly will — end in catastrophe. Inflation will follow. The peripheral countries will be hooked on printed money: they’ll never be able to return to the capital markets.

But that doesn’t mean that stock and commodity prices won’t get a big lift in the short-term. And smart investors might as well get ready for that.

July 20, 2011

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