The dam is breaking in Europe. Interbank lending has seized up. Much of the financial system is paralysed, setting off a credit crunch just as Euroland slides back into slump.

The Euribor/OIS spread or`fear gauge’ is flashing red warning signals. Dollar funding costs in Europe have spiked to Lehman-crisis levels, leaving lenders struggling frantically to cover their $2 trillion (£1.3 trillion) funding gap.

America’s money markets are no longer willing to lend to over-leveraged Euroland banks, or only on drastically short maturities below seven days. Exposure to French banks has been slashed by 69pc since May.

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Even as the euro zone hurtles towards a crash, most people are assuming that, in the end, European leaders will do whatever it takes to save the single currency. That is because the consequences of the euro’s destruction are so catastrophic that no sensible policymaker could stand by and let it happen.

A euro break-up would cause a global bust worse even than the one in 2008-09. The world’s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls….The euro zone could shatter into different pieces, or a large block in the north and a fragmented south. Amid the recriminations and broken treaties after the failure of the European Union’s biggest economic project, wild currency swings between those in the core and those in the periphery would almost certainly bring the single market to a shuddering halt. The survival of the EU itself would be in doubt.

Yet the threat of a disaster does not always stop it from happening. The chances of the euro zone being smashed apart have risen alarmingly, thanks to financial panic, a rapidly weakening economic outlook and pigheaded brinkmanship. The odds of a safe landing are dwindling fast.

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Of course, simply offering blank checks to the profligate is not a good solution either. But the current way the European Central Bank is acting may be the worst of all worlds. By buying government bonds while insisting it will soon stop, it is sending the message that bondholders had better sell quickly.

By contrast, if the bank made a promise to buy all the bonds that were offered to it ”” backed by its ability to print money ”” it might have to buy few bonds.

There is a real risk of moral hazard in central bank bailouts. The theory offered by Bagehot in the 19th century called for banks to make loans on securities that are of high quality and will be liquid when the panic passes, but not on low-quality securities. Telling the good from the bad during a panic is not always easy.

But we have until now assumed that a central bank would find bonds issued by its own government to be good paper, and investors could act accordingly.

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In one of the least successful debt sales by Europe’s powerhouse economy since the launch of the single currency, the low returns offered – just 2pc annually over 10 years – deterred investors made uneasy by the escalating cost of the crisis to Germany.

That meant the central bank had to pick up 39pc of the €6bn (£5.2bn) of debt Germany had hoped to sell after commercial banks bought just €3.644bn of the issue.

“It is a complete and utter disaster,” said Marc Ostwald, strategist at Monument Securities in London.

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Euro-zone leaders say they are determined to save the single currency. But the smart money is voting with its feet. First, short-term U.S. dollar-funding markets effectively closed, then the senior unsecured-bond markets shut down, then the interbank market. Now, corporate customers appear to be withdrawing their deposits from some countries’ banks. With an estimated €1.7 trillion ($2.29 trillion) of funding to roll over in the next three years, the stresses in the euro-zone banking system look doomed to get worse.

In some cases, the drop in corporate deposits has been startling. In Italy, nonretail customers withdrew €56 billion in the three months to the end of September, a fall of 12%. Intesa Sanpaolo and UniCredit saw corporate deposits decline by 16% and 10%, respectively, according to Citigroup research. Similarly, in Spain, nonretail deposits fell by 20% in the third quarter, with Santander and BBVA losing 10% and 11%, respectively. Even the French banks weren’t immune: Société Générale and BNP Paribas saw their corporate-deposit balances fall by 7% and 6%, respectively.

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Banks clamored for emergency funds from the European Central Bank on Tuesday, borrowing the most since early 2009 in a clear sign that the euro region’s financial institutions are having trouble obtaining credit at reasonable rates on the open market.

Indebted governments among the 17 members of the European Union that use the euro are also finding it harder to borrow at affordable rates as investors lose confidence in their creditworthiness.

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Ninety-three percent of Italians believe cutting the country’s hobbling public debt is a top priority, but few are willing to make personal sacrifices to do so, according to an AP-GfK poll released Tuesday.

Only about a quarter of Italians favor reforming labor laws to make it easier to fire workers, or raising the retirement age from 65 (and sometimes lower) to 67 – two of the reforms considered critical to curb Italy’s public spending and boost economic growth.

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Only the fiercely conservative stewards of the European Central Bank have the firepower to intervene aggressively in the markets with essentially unlimited resources. But the bank itself, and its most important member state, Germany, have steadfastly resisted letting it take up the mantle of lender of last resort.

European politicians and analysts say that unbending stance now threatens the survival of the euro and the broader integration of Europe itself.
“There is no solution to the crisis without the E.C.B.,” said Charles Wyplosz, a professor at the Graduate Institute in Geneva and co-author of a standard textbook on European integration. “The amounts we are talking about are too big for anybody but the E.C.B.”

At issue is whether the bank has the will ”” or the legal foundation ”” to become a European version of the Federal Reserve in the United States, with a license to print money in whatever quantity it considers necessary to ensure the smooth functioning of markets and, if needed, to essentially bail out countries that are members of the euro zone.

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Critics say Germany is falling between two stools. It has backed EMU rescues on a sufficient scale to endanger its own credit-worthiness, without committing the nuclear firepower needed to restore confidence and eliminate default risk in Spain and Italy. It would be hard to devise a more destructive policy.

There is no change in sight yet. Chancellor Angela Merkel repeated on Thursday that Germany would not accept joint EU debt issuance or a bond-buying blitz by the ECB. “If politicians think the ECB can solve the euro’s problems, they’re trying to convince themselves of something that won’t happen,” she said.

Yet she offered no other way out of the logjam, and each day Germany is sinking a little deeper into the morass.

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European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank.

The banks’ moves, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe’s already fragile financial system, say some senior industry officials and regulators.

They also are a sign that struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB. The Continent’s intensifying financial crisis has made it difficult for many banks to obtain funding from customary market sources.

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Virtually nothing is more sacred to Germans than their constitution, which is known as the Basic Law. It was originally planned as a stopgap measure, but it has seen the Federal Republic of Germany through the past 62 years. During the Cold War, political parties may have squabbled over conservative Chancellor Konrad Adenauer’s political commitment to Western Europe and the United States — and they had their differences over left-leaning Chancellor Willy Brandt’s Ostpolitik policy of normalizing relations with communist Eastern Europe, particularly with East Germany — but they immediately and unanimously praised the Basic Law. “We have one of the best constitutions in the world,” German Chancellor Angela Merkel once said.

Now, it looks as if Merkel herself may order an overhaul of the German constitution. At the party conference of the chancellor’s conservative Christian Democratic Union (CDU) which commenced on Monday morning, Nov. 14, it is expected to approve a plan that could change the face of Europe — and perhaps make it necessary for the Germans to rewrite their constitution.

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First it was Athens. Then Rome. Could Paris be next?

While Italy has replaced Greece as the focus of anxiety amid Europe’s worsening debt crisis, investors are increasingly concerned about the outlook for France, whose banks are among the world’s biggest and are closely linked with their counterparts in the United States.

One crucial gauge of investor sentiment, the difference between what France pays to borrow versus what Germany pays, has doubled since the beginning of October, and last week reached its widest point since the formation of the euro currency zone in 1999. Meanwhile, speculation that France could soon lose the sterling triple-A rating on its sovereign debt intensified after Standard & Poor’s mistakenly told clients on Thursday that it was downgrading France’s debt.

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Mr [Mario] Monti’s candidature was announced after President Giorgio Napolitano spent the day in 17 meetings with senior politicians.

Speaking to reporters shortly afterwards, Mr Monti said Italy should be an “element of strength and not weakness” within the EU.

“We will aim at solving the financial situation, resume the path of growth. [We want to build] a future of dignity and hope for our children.”

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A euro-zone central banker confesses that he has lately been thinking about historical catastrophes such as the first world war and wondering how the world blundered into them. “From the middle of a crisis”, he says ominously, “you can see how easy it is to make mistakes.”

Economic and Monetary Union (EMU) was supposed to banish the competitive devaluations that threatened the single market in the early 1990s. It promised to bind a unified Germany into the EU and pave the way for some sort of political union in Europe. Today that dream has not vanished altogether, but the single market is under threat once more. Europe’s nations are at loggerheads, Germany is in a state of outrage, and the link between the euro and the nation state is more fraught than ever. EMU truly is, writes David Marsh, author of a history of the euro, “Europe’s Melancholy Union”.

“The 2008 crisis shows that the dominant economies were not as dominant as they thought,” says Dominique Strauss-Kahn, the French former head of the IMF. “If Europe fails, it will suffer from low growth, economic domination and cultural domination.” Can Europe turn back from the abyss? Only if the core countries will support the rest as they submit themselves to radical political, social and economic reform. Nobody should be under any illusions about how difficult that will be.

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“We’ve entered a make-or-break scenario,” said Thomas Klau, a German who heads the Paris office of the European Council on Foreign Relations. “The present situation with Italy now is sustainable for days, perhaps weeks, but not months. This new chapter either writes the endgame of the euro zone, or it precedes a much bigger leap into political and economic integration than all those made so far.”

With each bout of uncertainty, speculative attacks come closer to the core of the European Union. Greece teeters, Italy wobbles and France begins to tremble. The precariousness of the situation was on full view Thursday when a leading ratings agency, Standard & Poor’s, mistakenly suggested on its Web site that it had downgraded France’s prized AAA rating, prompting a sell-off in French government bonds….

And it may get worse, with a recession looming. Unless, of course, the crisis has concentrated minds sufficiently, especially in Berlin. One of the first and most effective ways to combat the crisis and the potential downturn, experts say, would be to enable the European Central Bank, or E.C.B., to act as a lender of last resort, or to at least let it print some more money, to try a little inflation as a recipe for growth and debt reduction.

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For the second time in two years, European debt troubles threaten to slow the momentum of the fragile recovery in the United States.

Although American financial institutions have taken steps to protect themselves from Europe’s long-simmering problems, the likely slowdown in Europe could damage consumer and business confidence in America and strengthen the dollar, making United States exports less competitive.

“Financial contagion can lead to the very rapid global spread of recession,” said Chris Varvares, senior managing director for Macroeconomic Advisers, a forecasting company. “If trouble intensifies and spills over to equities and other U.S. risk assets, we could see a soft patch.”

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With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of €1,900bn. That would partially address its “stock” problem of large and unsustainable debt but it would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

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Italy on Wednesday became the first major economy to require an international bail-out as its debts hit “totally unsustainable levels”.

The country’s escalating crisis prompted questions about whether European leaders had sufficient will or financial firepower to rescue it.

The interest rate at which the Italian government borrows on the international bond markets hit seven per cent ”“ the point at which the smaller eurozone economies of Ireland, Portugal and Greece had to be rescued.

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Italy’s financial crisis deepened on Wednesday despite a pledge by Prime Minister Silvio Berlusconi to resign once Parliament passes austerity measures demanded by the European Union.

The move failed to convince investors, propelling Italy’s borrowing costs through a key financial and psychological barrier of 7 percent, close to levels that have required other euro zone countries to seek bailouts.

Mr. Berlusconi, cornered by world markets and humiliated by a parliamentary setback, appeared to have become the most prominent victim of the broader European debt crisis. But his decision did not remove wide uncertainty about Italy’s ability to tackle the crisis, and some analysts said the prospect of a protracted period of political wrangling could exert further pressure for a quicker exit from the impasse.

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Obama, at any rate, felt that they would have little value. Instead, he confronted the Germans in Cannes with a suggestion so radical that it alarmed both Merkel and Schäuble. To save the common currency, Obama proposed that the Europeans follow the example of the American Federal Reserve, which buys up almost unlimited amounts of US treasury bonds when necessary.

The Germans pointed out feebly that the ECB operates within a completely different tradition than the Fed, and that it also pursues a different mission. But it is becoming increasingly clear to Merkel and her finance minister that, in the end, only the ECB will be able to save the euro if the crisis continues to escalate. It is the only European fiscal policy institution capable of taking action, and it also comes equipped with unlimited firepower. It can never run out of money, because it can simply print new money when needed.

This is an approach Germany’s representatives in the ECB council have strongly resisted….But how long can the Germans resist the pressure from other members?

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Silvio Berlusconi, Italy’s embattled prime minister, signalled on Tuesday night that he would resign after parliament passes a new financial stability law that will implement fresh austerity measures demanded by the European Union.

Giorgio Napolitano, head of state, said Mr Berlusconi had expressed his recognition of the “urgent need” to respond quickly to the expectations of Europe through the approval of the stability law, which would be amended in light of the most recent recommendations of the European Commission.

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The lesson of LTCM was that no trading operation is better than its ability to withstand losses. This lesson was proved in spades, in 2008, at highly leveraged banks such as Bear Stearns and Lehman Brothers.

A second lesson is that seemingly unlikely events may be more likely than market history suggests. Russia had not defaulted since 1917, but that didn’t stop it from happening in 1998.

And a further lesson of LTCM’s demise was that the widespread belief that liquidity offers safety is, in fact, an illusion, and a terribly dangerous one at that.

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In response to the package, the bond market has not changed its tune. The new 50% “haircut” to private sector investors in Greece hasn’t altered the conviction of traders that the troubles in Athens will inevitably be contagious. Pricing of Spanish, Italian and even French bonds reflect this pessimistic outlook.

Europe’s politicians are aware of what the markets have long known: Patches are destined to fail. But the urge to pass the hot potato without instituting meaningful structural change is, evidently, irresistible. So instead of muscular reforms, we see the same unsuccessful rescue packages supersized. Sunny optimism and mutual back-patting continue, paired with pep talks from the rescue fund controllers at the International Monetary Fund and the World Bank.

The latest steps don’t end the Greek crisis. A Eurozone-wide problem requires a Eurozone-wide solution. The European Central Bank should be creating something along the lines of the U.S. TARP program, buying bonds to calm the volatility until a bold, permanent solution is crafted. Greece and the rest of Europe would ultimately survive the disintegration of the Eurozone and the death of the euro. But the end of a unified Europe would leave the entire world poorer.

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One is something we have now heard clearly from many sources ”“ a plea endorsed by the Vickers Commission that routine banking business should be clearly separated from speculative transactions. The rolling-up of individual and small-scale savings into high-risk and high-return adventures in the virtual economy is one of the more obvious danger areas. Early government action in this area is needed. A second plea is to recapitalise banks with public money. Banks should be obliged in return to help reinvigorate the real economy.

The third suggestion is probably the most far-reaching. The Vatican statement strongly backs the proposal of a Financial Transaction Tax ”“ a “Tobin Tax” or, popularly, a “Robin Hood Tax” in the form in which it has been talked about most recently. This means a comparatively small rate of tax (0.05 per cent) being levied on share, bond, and currency transactions and their derivatives, with the resulting funds being designated for investment in the “real” economy, domestically and internationally. The modest rate of taxation conceals the high levels of return that could be expected (some $410bn globally on one estimate)….

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Another note: Alert blog readers may recall that Rowan Williams’ arguments here are not new but they have been stated a number of times before.

A further update: I see Ralph Nader is in the Wall Street Journal making a similar argument for the Financial Transaction Tax.

Americans must not be smug about the suffering of Europeans””our financial system is thoroughly integrated with theirs. Moreover, the International Monetary Fund will most likely be involved in the event of future bailouts and will likely need large funds from its members, which ultimately means the taxpayers.

And, of course, the U.S. has its own large and growing public debt burden. We have not gone as far down the road to entitlements, but we are catching up. If you want to know how the debt crisis will play out here, watch the downward spiral in the EU.

Meanwhile, expect more volatility in financial markets. U.S. traders in particular simply have not grasped the enormity of the EU debt crisis.

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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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