Cantillon: contagion risk has not gone away

German economist Isabel Schnabel is not one to hold back. In Dublin yesterday, she took aim quite directly at an imminent European Central Bank move to loosen monetary policy. If you think ECB chief Mario Draghi has overcome his German doubters, think again.

The further Draghi goes on Thursday, the more noise there will be. In a sense, he is damned whichever way he turns. In December, a modest extension to the quantitative easing programme immediately irritated markets. This underscores huge market expectations right now.

In Prof Schnabel’s account, however, even a modest QE top-up will not go down well in the German Council of Economic Experts. “Do not ask too much from monetary policy,” she said.

There was more. On the future shape of the euro zone, Prof Schnabel reiterated the council’s call for a new insolvency regime to allow an “orderly restructuring” of sovereign debt with loss-sharing by private creditors. Such moves were cast to re-establish market discipline and reduce pricing distortions, the objective being to avoid repeating the Greek debacle.

This would necessitate the removal of priviliges for sovereign bank exposures in bank regulation, Prof Schnabel argued. Risk-adjusted limits on large sovereign exposures would be needed. So too would a €35 billion risk-weighted boost to bank capital. A long “transition phase” would be needed ease the changeover to the new world.

This raises slippery questions. First, there is the unresolved matter of more than €400 billion in legacy debt from the crisis. This remains a barrier to pan-European deposit insurance. Then there is the painful Deauville precedent of 2010 in which a Franco-German push to allow losses on sovereign bonds only hastened Ireland’s slide towards an international bailout. The flames of contagion took that to a dead-end.

Contagion risk has not gone away, of course. Although the option of an overwhelming show of ECB force remains, argument over the ECB’s quantitative easing scheme shows its manoeuvre room is limited. Like much else in the euro zone, the “sovereign insolvency” proposal is but a work in progress.