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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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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…rare is the analysis that traces all these problems back to the structural change in money that was brought about in the early 1970s.

We went from a hard-money regime, in which there were restrictions on the power of central banks and financial institutions to create money and credit, to one where money became purely paper. There were no restrictions remaining on the power of governments to finance unlimited debt. Banks could create credit seemingly without limit. Central banks became the real power in the world economy.

None of this was true under a gold standard. That system limits the expansion of credit by an indelible physical fact. There was a limit, a check, a rule that went beyond the whim of financial masters and politicians. The Vatican seems to understand this.

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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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The United States will likely suffer the loss of its triple-A credit rating from another major rating agency by the end of this year due to concerns over the deficit, Bank of America Merrill Lynch forecasts.

The trigger would be a likely failure by Congress to agree on a credible long-term plan to cut the U.S. deficit, the bank said in a research note published on Friday.

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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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The 17 European Union nations that share the euro don’t have that much time, of course, to convince investors that they have a plan to hold the currency together and prevent a run on the Continent’s banks. Some analysts say they have less than five weeks, until the Group of 20 summit meeting in November; others say a bit longer.

But rapid action comes hard to a union that works in increments, with political agreement required at every step.

In the short term, Greece remains the central problem. Two bailouts have not been enough. Greek public debt continues to mount, and so does the pressure on the government to find more revenue and make more cuts. Europe’s strategy, to the extent it can be discerned, is to put off restructuring Greece’s debt as long as possible and build up enough backing for a bailout fund so that banks with large exposure to the sovereign debt of Greece and other troubled euro-zone countries, like Portugal, Ireland, Italy and Spain, can survive an all-but-inevitable Greek default.

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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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