Martin McCauley writes from Frankfurt: So you thought the Eurozone problem had gone to sleep.

Wrong. Wrong, wrong, wrong!

It is coming back to bite everyone as they return from their sun, sand and sangria. In the sleepy month of August the European Central Bank (ECB) tried to pull a fast one. It intends to enter the markets and cap the differences between the bond yields of different countries. In simple language this means it will buy the bonds of the weak countries which have to pay more to borrow in the markets than the strong ones. As the resources of the ECB are limitless – it can just print more money – it hopes this will calm the markets and gradually eliminate the spread in interest rates. Some hope. The reason why Greece and Spain, for example, have to pay more to borrow is because the markets judge that they are a greater risk.

So let’s assume that the ECB gets its way and intervenes in the markets to bring down borrowing costs for the weaker states. What incentive is there for those countries to put their fiscal house in order? If rates go up the ECB will step in and start buying their bonds to bring it down. So there is no incentive whatsoever. The undisciplined will live at the expense of the disciplined.

What is behind the ECB’s initiative? The eurocrats in Brussels know that intergovernmental decision making is just about paralysed. Governments can simply not agree on the way out of the euro crisis. The idea is that the ECB should intervene when it judges that interest rates are too high. This is a political as well as an economic decision. So an unelected bank in Frankfurt would begin taking decisions which Brussels should take. Put another way the ECB’s action would be tantamount to it beginning to buy the sovereign debt of weak states. The problem is that its statute expressly forbids it to do so. The weakness of the Eurozone is that when the euro was launched fundamental problems were not resolved. Sovereign debt (a country’s national debt) was regarded as something which could be solved as it occurred. The thinking was that as problems arose member countries would be forced to compromise to solve them. For the euro to function properly as a single currency would oblige states to cede sovereignty in order to ensure prosperity.

The thorny problems of the euro were not addressed when it was launched because it was a time of prosperity. The good days were supposed to continue for ever. As everyone got richer nationalism would decline and the common interest would gradually take over. What a dream!

Markets were believed to be rational and would always correct themselves. That is what the mathematicians had demonstrated. So it was natural to believe that the Eurozone would find a solution to every problem eventually. If that could be done economically, then it could also be achieved politically. The latter was obviously the greater challenge. Rational markets would produce rational politics.

Well all those myths have been exploded. Markets are not rational. They can be as irrational as you and I. No human being always takes rational decisions. You are lucky if three quarters of your decisions are rational. So back to the ECB. It is a vain hope that markets will act rationally if the ECB intervenes to cap interest rates on bonds. The Germans know this but there are dreamers in the ECB and Brussels who do not.

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