The crisis of the euro zone has finally hit the potholed road of real politics, with the Greeks now openly questioning whether their commitment to Europe and its single currency still matters more to them than control over their own future and economic well-being.

During the two-year financial crisis, the wealthier countries of northern Europe, led by Germany, have insisted that their heavily indebted brethren in the south radically cut spending in return for emergency loans. They have stuck to that prescription even though austerity has undermined growth and increased unemployment in Greece, Spain, Portugal and now Italy, betting that people in those countries will swallow the harsh medicine because their only alternative is to default and possibly leave the euro zone altogether.

The turmoil in the government of Prime Minister George A. Papandreou means that Greece is about to call that bet. Many Greek politicians appear to be calculating, at this late stage, that they have more to lose by sticking to Germany’s terms than by risking a messy default, and even going it alone with their old currency, the drachma, outside the euro zone.

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Germans expressed fury and frustration at Greek Prime Minister George Papandreou’s shock decision to call a referendum on the latest aid package, with some saying the gamble would push Greece out of the euro zone.

“You can’t help thinking that they should be grateful as Europe is trying to help,” said Konstanze Pilge, a 26-year old student, walking near the Brandenburg Gate in central Berlin. “Now it looks like they are going to mess things up.”

Papandreou dropped his bombshell on Monday evening, less than a week after European leaders agreed the outlines of a second bailout for Athens.

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…the real drama Thursday was in the meeting with the bankers, held in the offices of Herman Van Rompuy, the president of the European Council, in the huge modern building here where the summit meeting was being held. Besides Mr. Van Rompuy, Mrs. Merkel and Mr. Sarkozy, others present were Christine Lagarde, the former French finance minister who runs the International Monetary Fund; José Manuel Barroso, president of the European Commission; and Jean-Claude Juncker, chairman of the euro zone finance ministers.

While they gave in, the bankers, represented by Charles Dallara, managing director of the Institute of International Finance, praised the deal. Later on Thursday, he explained to reporters that the bankers, too, were frightened of setting off a credit event, activating credit default swaps and other complex financial instruments, with unclear but potentially dire consequences for the global financial system.

“We attached a great deal of significance to this being voluntary,” Mr. Dallara said. “We knew what it would take in our mind in terms of the basic elements to be voluntary. It was not at all times clear through the negotiations that all parties placed the same priority on this being voluntary,” he said, an indirect reference to the German chancellor.

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As Sir John Major wrote this morning in the FT, this does not solve EMU’s fundamental problem, which is the 30pc gap in competitiveness between North and South, and Germany’s colossal intra-EMU trade surplus at the expense of Club Med deficit states.

It is therefore unlikely to succeed. It means that Italy, Spain, Portugal, et al must close the gap with Germany by austerity alone, risking a Fisherite debt deflation spiral. As I have written many times, this is a destructive and intellectually incoherent policy, akin to the 1930s Gold Standard. It risks conjuring the very demons that Mrs Merkel warns against.

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France is moving towards a moment of truth. The euro crisis, an unpopular president, rivalries within the Socialist party and a flatlining economy are forcing into question the balancing act performed by successive leaders for the past three decades. Abroad, the nation of Louis XIV, Napoleon Bonaparte and Charles de Gaulle likes to think of itself as Europe’s leader. This perception is now under threat. Meanwhile, at home, the very nature of the Fifth Republic is increasingly under question. Half a century after the general saved his country from disintegration and gave it a strong executive system of government, opinion polls suggest that an incumbent president could be defeated for the first time in 30 years.

Things will come to a head as France moves to its next presidential election starting in April 2012 against the backdrop of the European sovereign debt crisis, which began in Greece but has raised systemic political issues that France would rather avoid. Long gone are the balmy days of the 1980s when François Mitterrand, the former French president, and Helmut Kohl, erstwhile German chancellor, held hands at the first world war battleground of Verdun to symbolise the reconciliation between the two major protagonists of Europe’s 75-year civil war. Today, President Nicolas Sarkozy and Chancellor Angela Merkel peck one another on the cheek when they meet but, reflecting their nations, they are poles apart in temperament and mindset as they approach Europe’s existential challenges. While the Germans put their faith in rule-based systems, the French prefer to bank on their ability to conjure a solution out of adversity.

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European leaders have reached a “three-pronged” agreement described as vital to solve the region’s huge debt crisis.

They said banks holding Greek debt accepted a 50% loss, the eurozone bailout fund will be boosted and banks will have to raise more capital.

Shares on European markets rose sharply on news of the deal.

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The 14th crisis summit in 21 months starts with a meeting of all 27 European Union leaders at 6 p.m. The real business gets under way at 7:15 p.m. when chiefs of the 10 non-euro nations depart, leaving the rest to hash out a strategy that they already say requires more work.

The cancellation of a finance ministers’ meeting to precede the summit underscored the holes in the plan. The finance chiefs will now meet at an as-yet undetermined time after the summit to complete its main elements, including safeguarding banks and writing down Greek debt, according to an EU official.

Global exasperation with Europe’s response is deepening, with politicians from Australia to North America prodding the euro area to get ahead of the crisis before it infects the world economy.

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Italian Prime Minister Silvio Berlusconi was put on the defensive at a crisis summit over the country’s finances and appointments at the European Central Bank.

Before the leaders convened yesterday in Brussels, Berlusconi held face-to-face talks yesterday with European Union President Herman Van Rompuy and European Commission President Jose Barroso and then with German Chancellor Angela Merkel and French President Nicolas Sarkozy.

“I never flunked” an exam in my life, Berlusconi told reporters when asked if he was concerned over the push to cut Italy’s debt load, the biggest in the world after the U.S. and Japan.

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Just when the eurozone governments thought it could not get worse for Europe’s single currency, it did.

Shell-shocked EU finance ministers meeting in Brussels on Saturday were already reeling from the worst Franco-German rift for over 20 years and a fractious failure to resolve the problems that have brought Greece, and the euro, close to the brink.

But then a new bombshell hit as a joint report by the EU and the International Monetary Fund (IMF) warned that, without a default, the Greek debt crisis alone could swallow the eurozone’s entire €440 billion bailout fund – leaving nothing to spare to help the affected banks of Italy, Spain or France….

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EU ministers were wrangling on Saturday over bolstering their banks, with some officials saying broad agreement was nearing but others warning that Spain, Italy and Portugal were objecting because of concerns over the costs involved.

“There is 24 against three – Italy, Spain and Portugal,” said one euro zone diplomat. “They think it’s too expensive. They don’t want to pay it.”

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Expectations remained high on Friday that European leaders were trying to craft a bolder solution to the region’s financial crisis, despite clear signals from French and German officials that they have sharp differences heading into an important weekend summit in Brussels.

As ever, the focus is on Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France, who have made a habit of cobbling together deals to present to their European Union colleagues. But forging an agreement now is harder than before, as Paris and Berlin face core differences over how to maximize the euro zone’s financial rescue fund and how far the European Central Bank should intervene in the bond markets, either on its own or through the bailout fund.

Already the two leaders have announced that Sunday’s summit, which had already been delayed to allow more time for negotiations, would be followed by another summit meeting as early as Wednesday. That announcement, paradoxically, seemed to buoy stock and bond markets, apparently because the Europeans at least appeared to be focusing intensely on resolving the crisis.

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The current crisis over the euro has deep roots in the imbalances between north and south, rich and poor, export-led and service-driven economies, tied together by a currency but few rules, and those rarely enforced.

A fix will require fundamental changes in the functioning of the bloc, with more interference in the workings of sovereign states. There would need to be a fiscal union, with a treasury and a finance minister capable of intervening in national budgets, and more unified tax and pension policies. But it is far from clear that the European Union can gather itself to take these fateful steps away from nationalist identities to a truly European model.

“We are today confronted by the greatest challenge our union has known in its entire history,” said José Manuel Barroso, the head of the European Commission. “It is a financial, economic and social crisis. But also a crisis of confidence ”” in our leadership, in Europe itself, in our capacity to find solutions.”

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If it has been obvious for some time that we are caught up in an extreme financial crisis, the extent of its severity has acquired greater clarity in being described by the Governor of the Bank of England. Never before has the global financial system been so interlinked and integrated, which means that problems in one part of the world are capable of causing severe stress almost everywhere else. We once more face a perfect storm of cascading default, contracting credit and collapsing economic activity.

Yet, despite the parallels, the current situation need not end in the same catastrophe of economic, political and social meltdown as occurred in the 1930s. For most advanced economies, these outcomes are still avoidable. But escaping them is going to require leadership, nerve and collective resolve ”“ things that have so far been in short supply.

The problem is not in Britain ”“ which, despite the appalling legacy of debt left by the last government, is doing most of the right things ”“ but in mainland Europe, where lack of foresight, unwillingness to act, confusion of counsel and lack of clear thinking are indeed everywhere to behold.

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Money flows are even more out of kilter. Cross-border liabilities have jumped from $15 trillion to $100 trillion in fifteen years, or 150pc of global GDP. This creates a very big risk.

“Gross financial flows can stop suddenly, or even reverse. They can overwhelm weak or weakly regulated financial systems,” said Mr [Stephen] Cecchetti.

Well, yes, this is now happening. Did anybody think about this when they unleashed globalisation with its elemental deformity, free trade without free currencies?

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Greece’s government acknowledged Sunday that it will miss its deficit targets this year, but moved ahead with a controversial plan to slash thousands of public sector jobs to meet the demands of its international creditors.

“I want to repeat that we will be unswerving in our goal: to fulfill all that we have promised to ensure the credibility of our country,” Prime Minister George Papandreou told an extraordinary cabinet meeting called to approve the country’s 2012 draft budget as well as the job-cutting plan.

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We’re just stuck?

If we don’t deal with it ”“ if we don’t proactively say we’re going to get our deficit under control ”“let me put it this way: My personal belief is that if we do proactively get our long-term budget issues under control, the bond market will say, “Okay, you’re credible and we will buy your bonds, because you have put yourself on a credible path ”“ whether it’s through cuts, whether it’s through tax increases, however you want to do it ”“ but you have to do it. But you have shown us a credible way to get to the place where the growth rate of your deficit is below the growth rate of nominal GDP.”

But if we don’t do that, my wine bottle of pain becomes a jeroboam and we end up downing it all at once.

That sounds ugly.

It is. It will force budget cuts; it will force tax increases of the magnitude that no one is ready to contemplate. We’re talking cuts in Medicare, cuts in education, in defense, in spending of all kinds. That would create a depression, a true depression that would last 4-5 years, push unemployment to 20%-25%….

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Chancellor Angela Merkel won her “own majority” for the bill, narrowly averting the collapse of her government, but only after pledging that there was no grand plan committing Germany to vast and unlimited liabilities.

Horst Seehofer, leader of Bavaria’s Social Christians CSU, said his party would go “this far, and no further”, insisting any expansion of the rescue machinery was out of the question. “The financial markets are beginning to ask whether Germans can afford all this help. We must not risk the creditworthiness of the German state,” he said.

Norbert Lammert, the Bundestag’s president, said lawmakers felt they had been “bounced” into backing far-reaching demands and warned that Germany’s legislature would not give up its fiscal sovereignty to any EU body.

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The head of Europe’s markets regulator warned banks to be consistent in their valuations of sovereign debt amid concern some lenders have failed to record sufficient losses on Greek bonds.

Steven Maijoor, chairman of the European Securities and Markets Authority, likened the lack of transparency about banks’ individual holdings of government debt to the subprime mortgages that triggered the credit crisis.

“Lack of transparency regarding exposures to subprime mortgages created a situation of uncertainty about the financial positions of banks,” he said in a speech in Vienna today, according to a transcript released by ESMA on its website. Recently, “a lack of transparency from banks on their exposures to sovereign debt and related instruments are generating new suspicions about the conditions of individual banks and this requires similar answers in terms of transparency.”

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German lawmakers approved an expansion of the euro-area rescue fund’s firepower, freeing the way for European officials to focus on what next steps may be needed to stem the debt crisis.

The lower house of parliament passed the measure with 523 votes in favor and 85 against, granting the fund powers to buy bonds in secondary markets, enable bank recapitalizations and offer precautionary credit lines. It raises Germany’s guarantees to 211 billion euros ($287 billion) from 123 billion euros. The main opposition Social Democrats and Greens said before today’s session in Berlin that they’d vote with Chancellor Angela Merkel’s government, assuring passage.

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There is an optimistic scenario for the U.S. economy: Europe gets its act together. The pace of world growth quickens, igniting demand for U.S. exports. American politicians agree to a credible compromise that gives the economy a fiscal boost now and restrains deficits later. The housing market turns up. Relieved businesses hire. Relieved consumers spend.

But there are at least two unpleasant scenarios: One is that Europe becomes the epicenter of a financial earthquake on the scale of the crash of 1929 or Lehman Brothers 2008. The other is that Europe muddles through, but the U.S. stagnates for another five years, mired in slow growth, high unemployment and ugly politics.

No one would intentionally choose the second or third, yet policy makers look more likely to stumble into one of those holes than find a path to the happier ending.

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When Angela Merkel, the German chancellor, met Pope Benedict in Berlin last week, it appears that their conversation focused more on Mammon than on God.

“We spoke about the financial markets and the fact that politicians should have the power to make policy for the people, and not be driven by the markets,” Ms Merkel said after the talks. “This is a very, very big task in today’s time of globalisation.”

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Germany’s top judge has issued a blunt warning that no further fiscal powers may be surrendered to Europe without a new constitution and a popular referendum, vastly complicating plans to boost the EU’s rescue machinery to €2 trillion (£1.7 trillion).

Andreas Vosskuhle, head of the constitutional court, said politicians do not have the legal authority to sign away the birthright of the German people without their explicit consent.

“The sovereignty of the German state is inviolate and anchored in perpetuity by basic law. It may not be abandoned by the legislature (even with its powers to amend the constitution),” he said.

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Sitting in the modest living room of the home she shares with her parents, husband and two teenage children, Stella Firigou fretted about how the family would cope with the uncertainties of an economy crashing all around them. But she was adamant about one thing: she would not pay a new property tax that was the centerpiece of a new austerity package announced this month by the Greek government.

“I’m not going to pay it,” Ms. Firigou, 50, said matter-of-factly, as she lighted a cigarette and checked her ringing cellphone to avoid calls from her bank about late payments on a loan. “I can’t afford to pay it. They can take me to jail.”

While banks and European leaders hold abstract talks in foreign capitals about the impact of a potential Greek default on the euro and the world economy, something frighteningly concrete is under way in Greece: the dismantling of a middle-class welfare state in real time ”” with nothing to replace it.

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After a weekend of tense meetings among world finance officials here, euro-zone leaders were weighing options to maximize the size of their bailout fund by borrowing against it. The move could provide trillions of dollars of firepower to rescue governments and banks””-but only if all 17 euro-zone legislatures approve a two-month-old agreement to broaden the bailout fund.

Highly public opposition from Germany, the largest and most powerful euro-zone economy, could block the plan.

Policy makers are “focused on their own internal restraints, so that we don’t have the outcome that we need,” Antonio Borges, head of the International Monetary Fund’s Europe department, said Sunday. While key players were understandably acting in self-interest, he said, it was generating “disastrous” collective results.

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The reserve powers would be well advised to pull out all the stops to save Europe and its banking system. Together they hold $10 trillion in foreign bonds. If they agreed to rotate just 4pc of these holdings ($400bn) into Spanish, Italian, and Belgian debt over the next two years, they could offer a soothing balm. None has yet risen to the challenge. It is `sauve qui peut’, with no evidence of G20 leadership in sight.

Once again, the US has had to take charge. The multi-trillion package now taking shape for Euroland was largely concocted in Washington, in cahoots with the European Commission, and is being imposed on Germany by the full force of American diplomacy.

It is an ugly and twisted set of proposals, devised to accomodate Berlin’s refusal to accept fiscal union, Eurobonds, and an EU treasury. But at least it is big.

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The European Community has always been a project led by the elites of its member states. For most of its history, outside Britain at least, it enjoyed popular support because it delivered growth and prosperity, especially in its early years. But the last two decades have seen a big change. The treaty that set up the single currency obliged all member states of the now European Union, with the exception of Denmark and Britain who had opted out, to adopt it once they met the economic criteria. For the sake of the political dynamic, the criteria for joining were sometimes fudged. The more fragile economies struggled, especially when, faced with economic downturn and unemployment, they were bound by exchange rates and interest rates better attuned to the stronger economies than to their own needs.
Over the same period, the EU welcomed in the newly liberated countries of eastern and central Europe. Their acceptance by the existing membership has been the supreme achievement of the European Union to date: a brilliant act of generosity in the interests of peace and stability. But it has been accompanied by migration from the new member states on a scale that few anticipated. That in turn has contributed to massive social change. The resulting tensions have combined to turn public opinion away from support of the European Union and its institutions.

None of us can know whether the European Union could survive the break-up of the single currency. It looks for now as if the departure of some members is more likely than the demise of the whole project. And it may yet be that the crisis will finally bring about the central political governance necessary to make the currency a success. But the pressures of national public opinion make such a dramatic breakthrough very problematic.

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Before the euro zone, individual countries issued bonds in their local currency and could print more of it, whether it be francs, lire or drachmas, if a crisis was making it difficult to pay off the loans.

Today, with the European Central Bank in charge of euros, governments in Athens, Rome and elsewhere no longer control the “printing press.” Yet even as individual governments lost the power to pay off debts by printing money, the politics and regulations of the euro zone encouraged banks, insurance companies and other financial firms to load up on government bonds ”” and countries to issue them.

The “persistence in sustaining risk-free status .”‰.”‰. has, in our view, directly contributed to the development and severity of recent market turmoil,” Achim Kassow, a member of the board of managing directors of Germany’s Commerzbank, wrote in a recent study of the bank rule for the European Parliament. “Both the course and the severity of the crisis can clearly be tied to incentives set by current regulation.”

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There are many more reasons for concern. The continuing inability of Europe to cope with the euro troubles, the political impasse over economic policy in the United States, and the deer-in-the-headlights immobility of Japan do not inspire confidence. The emerging economies ”” China, India, Turkey and Brazil ”” face increased difficulties of their own and will not pull the global economy out of the dumps. That large corporations are sitting on cash hoards or buying back stock rather than making new investments is bad news; that consumers are cutting down debt and doing what they can to increase their savings is good news for the long term, but bad news now. And it seems clear that two years of frantic efforts in Washington have failed to breathe new life into the nation’s housing market….

Global economic events are moving so rapidly that we have no way of foreseeing the economic environment for next year. It will probably not be very good, but how bad it will be and how it will look to voters cannot yet be foretold.

More to the point, we need policy discussions more than we need political ones. This is not just about how big the deficit should be; it is about whether the international financial system will survive the next six months in the form we now know it. It is about whether the foundations of the postwar order are cracking in Europe.

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Key indicators of credit stress have reached the danger levels seen before the Lehman Brothers failure three years ago, with Markit’s iTraxx Crossover index ”“ or “fear gauge” ”“ of corporate bonds surging 56 basis points to 857 on Thursday….

The yield spread between Italian 10-year bonds and Bunds reached a fresh record of 408 basis points before the European Central Bank (ECB) intervened in late trading. It is near the level at which LCH.Clearnet raises margin requirements, the trigger that forced Greece, Portugal and Ireland to request bail-outs.

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Cutting its global forecasts sharply, the world’s economic watchdog said the global economy had entered a “dangerous new phase” and urged policymakers to tread a careful line between aggressive deficit reduction and growth. Central banks should stand ready to restart the printing presses to aid the recovery, it added in its twice-yearly World Economic Outlook.

“The recovery has weakened considerably. Strong policies are needed to improve the outlook and reduce the risks,” Olivier Blanchard, the IMF’s chief economist, said. “Markets have clearly become more sceptical about the ability of many countries to stabilise their public debt. Fear of the unknown is high.”

Europe’s leaders came under scathing criticism over the escalating debt crisis.

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