Lender of last resort...

There is a reason why the Euro-zone seems unable to get itself out of the quagmire. It is dealing with the growing problem in a passive-reactive manner. There is a discernable pattern here:

1. the crisis shows signs of brewing
2. the core members of the zone get together to discuss the problem
3. at the meeting they announce that they have reached an agreement to boost the limit of the "bailout" fund
4. the markets react favorably for a day or two until the cycle is repeated again.

With a moving target in a deteriorating environment, it is difficult to see how readjusting the size of the bailout could ever work. Most of what is going on is psychological to begin with. The markets are very much aware that the tools the euro-zone members have at their disposal are insufficient to tackle the problem.

Psychology works in funny ways, we tend to overshoot all the time. In a stable environment, greed takes the upper hand whilst fear tends to reign when markets are in turmoil. In both cases there are exaggerations and the degree of the exaggeration depends very much on the circumstances of the time. It seems clear to me at least that the current approach has failed but what is more worrying is that the window of opportunity for the zone to extricate itself out of the quagmire is rapidly narrowing. Soon the only option on the table to avoid a meltdown will be to take out the heavy weapons.

The ECB, unlike many other central banks, does not have a mandate as lender of last resort and it may unwilling to use this option to avoid encouraging the risk of "moral hazard" down the line but it may end up being the only effective way to quash the psychological effect. The reason why this would work is because the human mind is much less effective in dealing with the concept of infinity: If you announce that you are taking a stance in the markets and you have close to unlimited resources to defend your stance, it will be far more credible than if you announce the ceiling of your resources from the very beginning. The Swiss National Bank's intervention in defense of the Swiss franc is a perfect example of this!

From idiosyncratic to systemic...

It is crucial to distinguish idiosyncratic risk from systemic risk. The former is related to risk that originates from or is inherent to a specific entity such as a firm, whilst the latter is risk that is exogenous to the firm. The reason why making a clear distinction between the two risks is so important is because their expected antidotes are so different. Idiosyncratic risk is normally handled by the management team of the firm and only involves outside intervention in situations of "too big to fail" where repercussions in terms of systemic risk become all too real. Systemic risk, on the other hand, is usually beyond the scope of management, it is more within the domain of policymakers.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.

It seems to me that the original architects of the Euro-zone project are now paying a heavy price for having suppressed the major risks or negative points that were outlined in the independent study on the creation of a Euro-zone that had been commissioned by the core governments of the project. As we can see from the CDS graph of Italy, it is just another example of too little, too late.