Dangerous jabs at a sleeping debt dragon

Last July the European Central Bank president created a significant turning point in the post-crisis environment with a spectacularly successful piece of ‘jaw-boning'. His vow to do ‘'whatever it takes'' to preserve the euro instantly calmed fearful debt markets, saw the cost of eurozone sovereign debt tumble and ignited a global surge in equity markets.

The promise alone was sufficient to calm markets, with the ECB not actually doing anything of consequence. It was interpreted as a statement of the central bank's willingness to print as much money as required to buy eurozone sovereign debt and hold the eurozone together.

Draghi's commitment was, if the markets' behaviour is any guide, seen as unconditional. In fact, however, there was some fine print involved. The ECB's Outright Monetary Transactions program, however, is heavily conditional. The ECB support is only available to governments that commit to fiscal and economic reforms.

That's why the messy and inconclusive outcome of Italy's election and the clear rejection of Prime Minister Mario Monti and his reform program represents a very real threat to eurozone and global stability. The Italians have rejected Monti's version of austerity, which is regarded as significantly less austere than that which would be demanded as the price of ECB support.

With about $2 trillion of debt and a public debt-to-GDP ratio of about 125 per cent a blowout in the cost of servicing that debt would plunge Italy and the entire eurozone back into crisis.

While Draghi spoke of a ‘'positive contagion'' earlier this year when describing the effect his comments last July had on markets and sentiment there, now there is a renewed prospect of the kind of conventional contagion that had previously destabilised the eurozone.

With the eurozone's real economies showing no signs of life, the citizens in the most-stressed economies of southern Europe sharing the Italians' distaste for austerity and the Europeans making only the smallest of steps towards the restructuring and harmonisation of their banking sectors, economies and governance that would be required to make sense of a common currency, the breathing space that Draghi created last year hasn't been used to reduce the vulnerability of the region.

In the US, meanwhile, Ben Bernanke settled markets uneasy about the developing tensions within the Federal Reserve board over the future of its quantitative easing programs. Although he did note the threat to the US economy posed by the massive automatic spending cuts due to occur on Friday unless the Democrats and Republicans can agree upon another eleventh-hour deal.

It has been clear from the Fed's recent minutes that there is growing concern about the unintended consequences of the Fed's continued large-scale bond and mortgage-buying, which has encouraged flows out of bonds and into riskier asset classes and which has some Fed members concerned about its potential impact on financial stability. There are also, of course, potentially longer term implications for inflation in the US.

While Bernanke accepted that prolonged periods of ultra-low interest rates could damage financial stability, he made it clear that for the moment he believes the benefits of quantitative easing and the Fed's $US85 billion-a-month of asset purchases in promoting economic recovery outweighed the risks.

He may or may not be right. The deferral rather than resolution of the US 'fiscal cliff' stand-off earlier this year, the wrangling over the ‘sequestration' or automatic spending cuts and the reality of the $US16 trillion of government debt – more than 100 per cent of GDP – means that the US, too, has some massive and potentially destructive issues of its own to resolve.

The accelerating momentum in equity markets over the past seven months since Draghi made his ‘'whatever it takes'' stand seemed to be founded in a conviction that the eurozone crisis had been resolved and that the Fed would be able to similarly continue to do whatever it took, despite the politicians, to maintain the weak US economic recovery.

The Italian elections and the apparent inability of the Democrats and Republicans to agree on anything, however, have sent a very clear message that the structural threats to the global economy and to global financial stability that are latent, albeit dormant, in Europe and the US have yet to be addressed, let alone dealt with.