A year ago, Germany and France could probably have saved the euro--at least for a time--by stepping in to guarantee all the debts of the peripheral euro zone nations.  To be sure, this would have created quite a lot of other problems, but it would have saved their banks and their currency union.

However, a year ago, governments were nowhere near ready to take such drastic action: the French and German governments didn't want to put their credit rating behind Greek profligacy, and their voters wouldn't have stood for it if they'd tried.

At this point, however, with the panic in full flight, it's not entirely clear to me that even a 100% guarantee would staunch the bleeding for more than a short time.  Do the Germans really have enough to guarantee the debts of most of the rest of the euro zone?

Before you answer that, ponder the lesson of this crisis (and the Great Depression): bank crises are ultimately sovereign debt crises.  Given the size of modern states, and the complexity of modern economies, a broad banking crisis forces the sovereign to step in (and if they don't, it vaporizes so much tax revenue that from the perspective of their creditors, they might as well have).

Effectively, Germany and France and a handful of other tiny countries have to guarantee both the sovereign debt and the bank liabilities of the whole eurozone.  Given the holes that recent events have exposed in these systems, can they credibly do that?  Even if the Greeks and Italians don't use that guarantee as a blank check to avoid reform?

We may be getting an unhappy answer to that question: a German bond auction went rather badly today.  In fact, a lot of commentators are using words like "disastrous".  They sold just over half of the €6 billion they had put out to market, the worst such outcome anyone can remember.  This comes on the heels of a Spanish debt auction in which the yields on their three month notes more than doubled to 5%.  That's a higher interest rate than I pay on my credit card.

I've seen three explanations offered for this:

  1. The market is pricing the euro, not German credit
  2. Bund yields, at 1.98%, are too low to be attractive
  3. European banks are delveraging, depriving the auction of buyers
#2 is actually just a special case of #1--people used to like to buy ultra-low bunds as a safe-haven, and now they don't.

In an excellent post at The Economist, Ryan Avent offers some wan reason for optimism: "The good news, such as it is, is that the stunning German bond-market failure may shock leaders their into recognising their own great vulnerability and pushing for bold initiatives to slow the crisis."  But of course, as he goes on to point out, the auction suggests that shocking German and French leaders is no longer enough (France is also under attack, and threatened with a ratings downgrade).  

After all, you can view the failed auction as a referendum on the instability of the euro, and hence the German banking system, in which case maybe "fixing" the euro with German guarantees fixes the problem.

But you can also view it as a referendum on membership in the euro, full stop.  The market may be saying that as long as Germany is tied to these other, troubled, countries, their debt looks more dangerous.  In which case, deeper integration doesn't really help.

I suspect we'll find out in the days ahead.  At this point, the ECB is the only player left with clear and untapped intervention potential.  But even that may be waning fast.

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