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The Eurozone’s Fork in the Road

BUENOS AIRES – Many observers have recently declared that the eurozone debt crisis is practically resolved, or at least on hold for a few years. The falling yields at the Italian government’s last bond auctions in 2011 suggested a significant reduction in the perceived sovereign-default risk. Since Italian bonds are regarded as the bellwether of the crisis, many interpret this is a sign that the European debt market is normalizing.

The “solution” to the crisis was putatively facilitated by the European Central Bank’s decision to lend unlimited funds to commercial banks for three-year terms at very low rates. But a central bank would normally do even more to fulfill its role as lender of last resort. So why all the renewed optimism?

The immediate answer is that national banks will now use the scheme to borrow cheaply from the ECB and invest in short-term sovereign bonds, using the interest-rate spread to create a profitable “sovereign carry trade.” Despite the inefficiencies and distortions arising from such monetary financing, the ECB may indeed provide some breathing space for governments.

But the real reason why this otherwise standard policy decision seems like such an important step is that, for the first time, the ECB has recognized the need to address a fundamental flaw in the eurozone’s architecture: the ECB itself.