The world’s financial system is entering dangerous waters again, warns guru of the Lehman crisis

The perennial locus of trouble is Europe’s half-built monetary union, where the bond-buying spree of the European Central Bank has mopped up Club Med (and French) debt issuance as if there was no tomorrow, and tomorrow has now arrived.

“Could Italy get bad quickly? Yes, it certainly could,” he said.

Italy’s 10-year bond yields have tripled this year to 3pc. Risk spreads have ballooned to 200 basis points, higher than they were when Mario Draghi was drafted by the political elites to save the country.

Prof Tooze said the ECB has no credible mechanism to defend the southern European states as QE winds down.

“They’re talking about a ‘spread-management’ instrument and telling us they’ve got a magic bullet, but the markets don’t believe it,” he said.

Such an instrument, if it ever emerges, moves beyond anything plausibly billed as monetary policy. It looks like a naked rescue of insolvent sovereign states in breach of EU treaty law, and invites a challenge at the German Constitutional Court. It is anathema for northern hawks alarmed by the ECB’s slide into fiscal dominance.

“We all know that if there was a legal way to control yields they would already have used it. So it is just sleight of hand,” he said. The ECB can “skew” the reinvestment of its existing portfolio to vulnerable countries but that is a token gesture.

A fresh spasm of Club Med debt angst is coming as market vigilantes test the ECB’s ability to act. The exchange rate will take the strain: Europe’s € 2 trillion investment giant Amundi says it expects the euro to hit parity against the dollar this year.

Prof Tooze does not think euroland will disintegrate. Europe’s leaders cannot let that happen, but neither will they resolve the incoherence of an orphan currency union without fiscal union. “The whole eurozone has been in suspended disbelief for years. It ought to blow up but it never does because somehow they find ways to improvise,” he said.

That does not exclude a crisis along the way, and Italy is the stand-out candidate because it has incendiary politics as well as zero trend growth and a debt ratio of 151pc of GDP. The unelected Mr Draghi will soon be gone and the eurosceptic hard-Right leads the polls. Markets will test that too.

The silver lining is that inflation works wonders for debt-dynamics. It erodes the real burden of legacy borrowing through the denominator effect. People across the West should stop fretting about the CPI horror story and remember that bond holders – with broad-shoulders – are paying the main tab for the pandemic.

“Two or three years of inflation above 5pc is beneficial: it burns off the debt. But you have to protect vulnerable people from real income losses. That is a poverty problem, and there are policies to address it,” he said.

The UK is assuredly not addressing it. The Government is pushing through the fastest fiscal retrenchment in the developed world seemingly in the belief that public debt is nearing a critical threshold, or judging that mid-sized open economies with big trade deficits cannot take risks.

“It is a rerun of the 2010 panic, but without the rhetoric. I don’t see how they are going to build a working class coalition like this,” he said.

The arguments over austerity have never been settled. There is a persuasive case that a fiscal squeeze at the wrong moment and at the wrong therapeutic dose is counter-productive on its own terms. It does not lower the debt ratio more than would otherwise occur, leaving aside the lost economic growth and social misery caused along the way.

America is doing its own variant of austerity-lite, swinging abruptly from eye-watering deficits to a negative fiscal impulse, but not because the White House has chosen to do so. Joe Biden cannot get his spending packages through Congress.

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