EUROPE - Italian economist, Harvard academic and former member of the executive board of the European Central Bank Lorenzo Bini Smaghi has said he is "not pessimistic" about the long-term future of the euro, but warned that European authorities' "inefficient" habit of reacting to rather than anticipating market pressures would lead to "a lot of volatility in the short term".

In an impassioned defence of the single currency at the 6th DWS European Investment Conference in Rome, Bini Smaghi took aim at apocalyptic comment around the euro-zone crisis, saying that it draws strength from the political project of European integration, but was also a genuine response to the economic needs of the single market.

"The euro was not perfect from the start, and I think most of us knew it," he said. "So why did we create it despite this?"

Bini Smaghi conceded that Europe was never an optimal single currency area, but pointed out that having 17 different free-floating currencies was not optimal, either.

"How would that regime have responded to the financial crisis?" he asked.

Switzerland's response to the crisis has been to peg its currency to the euro, he observed - hardly a ringing endorsement for the stability of staying out of the single currency.

Bini Smaghi also noted that the US financial system was not created perfect: the Federal Reserve was formed in response to multiple banking crises.

"At least in the euro-zone, we started with a central bank lender of last resort," he said.

He also pointed to progress that has been made. It would have been inconceivable two years ago that Germany would vote to lend to Greece and support a new fiscal treaty, he suggested.

"Europe has changed - but, in reality, markets are less resilient than they were two years ago," he said. "Why is that?"

The answer lies in the reactive approach of Europe's authorities. But in a way this is unavoidable, Bini Smaghi argued.

The solution is simple on paper: a Eurobond that creates joint-and-several liability. But that is unrealistic because of the moral hazard it would entail.

The dangers have been demonstrated over the past winter, when complacency after fiscal agreements and the ECB's LTRO led to privatisation and structural reforms being watered down.

"But moral hazard has become such an obsession that now maybe it is too much," Bini Smaghi suggested.

"We saw with Lehman that avoiding moral hazard is not necessarily the right response in a crisis. I don't think letting Lehman go bankrupt has led to a new generation of cautious bankers."

As such, he noted that while the ECB was constrained by it price-stability mandate, the very narrowness of that mandate opened up the possibility of radical action.

"As long as price-stability is observed, the ECB can act substantially," he said. "The size of the ECB's balance sheet causes some concern, but, as an ex-central banker, I can say that is over-exaggerated."

Inflation comes from the flow of money into the real economy, not simply from the size of the central bank's balance sheet, he explained - and that flow is decreasing, according to the latest data.

In fact, in this risk-averse environment, an expanding balance sheet is all that stands in the way of a credit crisis and outright deflation, Bini Smaghi argued.

It would be more dangerous if markets lost confidence in the ECB's ability to act.

And so Bini Smaghi's speech was ultimately a call for institutions to evolve their mandates to meet the extraordinary demands of the crisis.

In its reactiveness, this is not perfect, he acknowledged, but it is the way institutions have tended to evolve in the past, and it is the only way to avoid genuine moral hazard.

If they succeed, he implied, the road may be bumpy as the markets test their limits - but we will reach the destination in the end.

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