The Most Important Question in Europe: To Bailout or Not to Bailout?

Germany has to decide what to do with Spain -- and soon.


I've got some shocking news for you. Things are going badly in Europe.

The big story is Spain's borrowing costs. On Thursday yields on 10-year Spanish bonds touched the dreaded 7 percent level -- which they have continued to flirt with on Friday. What's so important about 7 percent? Two things. First, banks have to post more margin -- i.e., cash -- if yields cross that threshold when they use bonds as collateral. A downward spiral awaits. Banks might sell the bonds off because they aren't as useful -- leading to higher yields and worse margin requirements. And so on, and so on. But it doesn't even really matter. Borrowing costs of 7 percent are already ruinous for Spain. As Brad Plumer pointed out, inflation is so low in Spain that its economy would have to grow at a 4-5 percent clip to not fall into a debt trap with yields that high. But Spain isn't growing at 4 or 5 percent. Spain is in a recession.

So yes, it's fair to call the week-old bailout of Spain's banks a failout. The putative bailout has 1)  Added to Spain's public debt, 2) Made that debt riskier, and 3) Likely made it harder for Spain to pay back its debt. The euro zone can hardly take any more such successes.

But the financial apocalypse isn't here yet. Just close. Spain relies on a lot of shorter duration debt to fund itself too. The borrowing costs on those bonds are still semi-manageable -- for 2-year bonds, if not 5-year bonds. Still, Spain is far too close to insolvency for comfort. Unless the European Central Bank (ECB) pushes down yields, Spain will need another bailout. And soon.

That brings us to the most interesting euro development of the past week. German bonds started to sell off -- before rallying recently. This was ... odd. German bonds never sell off when things look bad in euroland. The opposite. There's usually a flight to safety to them. If there's one euro zone country that won't go bankrupt, it's Germany. But things are getting so bad in Spain that Germany might have to cross the financial Rubicon it's so far been unwilling to countenance: joint debt.

Spain is too big to save. But that's almost irrelevant. The bailout status quo is toxic. It hasn't solved anything for Greece, Portugal or Ireland. It won't for Spain either. Southern Europe needs to reduce its debt and reduce the interest it pays. Bailouts do the latter, but not the former. But mutual debt -- so-called "eurobonds" -- would work. There's a problem. Germany doesn't want to give southern Europe a credit card with no limit. Germany wants there to be a very specific limit. That's where the so-called "sinking fund" comes in. The idea here is that each country would dump all of its debt in excess of 60 percent of GDP into a single fund. Each country would have to pay its own portion back over 20 years, but Europe would issue debt jointly.

This isn't a fiscal union. It's not an open-ended bailout of Spain by Germany. It's a one-time bailout of Spain by Germany. It's not perfect, but it could work. And it would cost Germany a good chunk of change. That's why Germany's borrowing costs surged at the beginning of the week. Of course, Angela Merkel gave her best Herman Cain impersonation later -- Nein, nein, nein! -- which is when German borrowing costs receded.

Germany will have to make up its mind soon. Markets don't have much patience for its Hamlet act. Time to decide whether the euro will be or not be.