By Ambrose Evans-Pritchard

LONDON, England - November 14, 2010 - It is the European Central Bank that should be printing money on a mass scale to purchase government debt, not the U.S. Federal Reserve.

Unless the ECB takes fast and dramatic action, it risks destroying the currency it is paid to manage, and allowing a political catastrophe to unfold in Europe.

If mishandled, Ireland could all too easily become a sovereign version of Credit Anstalt - the Austrian bank that brought down the central European financial system in 1931, sent tremors through London and New York, and set off the second deeper phase of the Great Depression, the phase when politics turned ugly.

“Does the ECB understand the concept of contagion?” asked Jacques Cailloux, chief Europe economist at Royal Bank of Scotland. Three EMU countries have already been shut out of the capital markets, and footloose foreign creditors hold €2 trillion of debt securities issued by Spain, Portugal, Ireland and Greece.

“If that is not enough to worry about financial contagion, what is? The ECB's lack of action begs the question as to whether it is fulfilling its financial stability mandate,” he said. That is a polite way of putting it.

The eurozone’s fiscal fund (European Financial Stability Facility) is fatally flawed. Like Alpinistas roped together, an ever-reduced core of solvent states are supposed to carry the weight on an ever-widening group of insolvent states dangling beneath them. This lacks political credibility and may be tested to destruction if - as seems likely - Ireland is forced to ask for help. At which moment the chain-reaction begins in earnest, starting with Iberia.

It was a grave error for Germany’s Angela Merkel and France’s Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder “haircuts” at this delicate juncture, ignoring warnings from ECB chief Jean-Claude Trichet that such talk would set off investor flight from high-debt states.

EU leaders have since made a clumsy attempt to undo the damage, insisting that the policy shift would have “no impact whatsoever” on existing bonds. It would come into force only after mid-2013 under the new bailout mechanism. Nobody is fooled by such a distinction.

“This is a breath-taking mixture of suicidal irresponsibility and farcical incoherence,” said Marco Annunziata from Unicredit.