As predicted on this blog two weeks ago in EuroJenga Blocks for Christmas, the bond market panic caused by Angela Merkel’s “burning of the bridges” has succeeded in foreclosing all other options for the hitherto unfocused ECB except one:

What if Merkel’s remarks were coldly calculated precisely to force the ECB into the breach? Clearly, with the spectre of deflationary collapse urging politicians to “do something”, unlimited Eurozone sovereign debt purchases by the ECB would let German banks off the hook and would also help Germany’s industry and economy indirectly via the ensuing devaluation of the Euro.

With the ECB being forced to join the EuroJenga game and poised to take the next turn, likely this coming Sunday if past experience is any guide, the bond markets are pausing to see what this will mean for the entire Euroland tower of debt.

Specifically, Mr Trichet has reminded the markets that moral hazard is still alive and well, and that the ECB would do its part as the buyer of last only resort. In a post on the ‘naked capitalism’ blog titled The man with the magic words, Richard Smith explains how Trichet managed to placate the bond markets:

Mr Trichet also hinted that the ECB could extend its purchase of government bonds, a controversial move within the ECB governing council, saying he could not discuss the issue “at this stage” but that further decisions on the programme would be taken by the board.

The bond markets, which had brushed aside the Irish bailout, and were clobbering not only Greek, Irish and Portuguese debt, but also Spanish, Belgian and even Italian, took a hint that at last there would be a bid somewhere for the less exalted Eurodebt, and backed off. Whether Trichet’s bond purchase programme turns into the EUR2 Trillion monster now envisaged by market participants, or not (the ECB has only purchased EUR70 Billion of bonds so far, which doesn’t imply great willingness to go down this path), we have at least a pause in what, on Monday and Tuesday, looked ominously like a slide towards panic.

Let’s be optimistic and assume that the ECB will go for “shock and awe” of the EUR 2 trillion kind. Is that it – will unlimited bond purchases by the ECB lead the Eurozone out of the woods? The answer, given by Walter Münchau in September, is that the banking crisis will go “on and on and on”, and that “we will still be talking about it in five years’ time”. As long as the underlying problem (according to Willem Buiter) is the solvency of overindebted sovereigns being (correctly) called into question by the markets, against a backdrop of a decade-long balance sheet recession, and as long as the preferred solution to the insolvency problem is to keep avoiding the politically unpalatable decisions and to keep refinancing with yet more debt, the Eurozone cannot possibly arrive at the permanent stability it seeks. The bond market vigilantes will surely be back. In Jenga terms, at the end of the ECB’s turn the tower may still be standing, but by definition it will be taller, more unstable, and make for a far more spectacular crash if an orderly disassembly and re-assembly proves impossible in future.