By Ambrose Evans-Pritchard

LONDON, England - August 4, 2011 - The European Central Bank has abandoned Italy and Spain to their tortured fate.

Its refusal to act in the face of an existential threat to monetary union has set off violent tremors across the global financial system, raising the risk that the crisis will spiral out of control.

Bank shares crashed in Madrid and Milan, with Intesa Sanpaolo down 10% and Italy's MIB index reduced to its knees with a one-day fall of 5.2%. Share trading was suspended at a string of bourses across Europe.

Yields on 10-day U.S. debt fell to zero in a replay of panic flight to safety seen during the onset of the Lehman-AIG crisis three years ago.

Jean-Claude Trichet, the ECB's president, said the bank had purchased eurozone bonds for the first time since March but this token gesture was confined to Ireland and Portugal, countries that have already been rescued.

Professor Willem Buiter, Citigroup's chief economist, said the apparent ECB action was pointless. "The warped logic of intervening in two countries that don't need it is as strange as it gets."

Mr. Buiter said Europe risks a disastrous chain of events and the worst financial collapse since the onset of the Great Depression unless Europe's central bank steps in with sufficient muscle to backstop the system.

"The ECB has yet so show it understands that it is the only institution that can save Italy and Spain from fundamentally unwarranted defaults. Everybody is afraid and real money investors are dumping their holdings. The ECB must step in to cap the yields at 6% or 6.5% and put a floor under the market," he said.

Italian yields spiked to 6.21% yesterday after a relief rally wilted. Spanish yields hit 6.3%. The debt of both countries is hovering near 400 basis points over German Bunds, 50 points shy of the level used by central clearing house LCH.Clearnet to trigger margin calls. This was the point where the debt crises of Greece, Ireland and Portugal crossed the line of no return. Spain has cancelled further debt auctions in August.

"As long as the ECB stays on the sidelines, a speculative, fear-driven withdrawal of market funding can feed a self-fulfilling insolvency. Any number of banks and insurance companies would take huge hits. The ECB will have to come in, or accept the biggest banking crisis since 1931," Mr. Buiter said