Optimists might have hoped that we had heard the worst last week when Brussels confirmed that Spain would receive a €100 billion (£80,000,000,000) bailout package from Europe to rescue its stricken banks. On past form, this telephone-number intervention should have steadied the heaving eurozone ship after weeks of anxiety. Instead it took just hours before investors resumed dumping assets as fears took hold about how the bailout conditions would affect their investments. This drove up borrowing in Spain, and to a lesser extent Italy, to levels bordering on unsustainable.
Bearish voices had always said the trouble would really start if Europe's fifth and fourth-largest economies fell over the edge. Now – just as the Greeks go to the polls in their all-important general election rerun – that could be exactly what is happening.
It didn't matter that the Spanish national public finances have been in relatively good shape until now. The national debt is in the same territory as France and Germany (albeit the deficit needs to come down). Prime Minister Mariano Rajoy had earned plaudits from the world of international finance for inflicting a model austerity regime on the country.
But Spain has a big problem. Like Ireland and the UK, its property prices went berserk in the boom times. Its dusty plains are full of half-finished developments and shiny new homes growing dilapidated because nobody could find a buyer. Unlike other countries' banks who several years ago began unwinding the carnage that these stupid lending decisions had left on their balance sheets, Spanish lenders had held out in the hope that prices would pick up.
It is only now they are facing the reality. To make matters worse, they also lent heavily to Spanish regions that are now broke; and are heavily invested in Spanish sovereign bonds falling in value by day.
Matters came to a head in the wake of last month's Greek electoral turbulence, when Spanish depositors started withdrawing money en masse for fear their banks might collapse. In the same way as the UK had to shore up the likes of Northern Rock and RBS, Spain was clearly now going to have to intervene. But with the interest rates (yields) on Spanish sovereign debt about three times that of the UK, it could not afford to borrow the money on the markets.
Hence the bailout. Rajoy insisted to the Spanish people that it was a triumph, but the markets were soon asking thorny questions about repayment terms and how it would impact Spanish finances. The situation went from amber to red as credit ratings agencies downgraded Spain and its banks, prompting the interest rates on Spanish sovereign bonds to cross 7% on Thursday – the all-important level beyond which heavily indebted governments become unable to repay (they came down slightly on Friday, possibly through emergency buying from the European Central Bank (ECB)).
This happened to Italy during a previous nadir last November. At that time the eurozone was able to settle nerves by installing Mario Monti as a technocrat prime minister in place of the ridiculous Silvio Berlusconi and unveiling a package of tough reforms.
This time, however, no such obvious sacrifice is available. Spanish foreign minister Jose Manuel Garcia was reduced to publicly calling on the ECB to start buying Spanish bonds to help bring down rates, warning that the fate of Europe could be decided in hours rather than days.
Gabriel Sterne, an economist at Exotix, says the risk now is that Spain will need more money to prop up day-to-day government spending. "When yields get to 7% it becomes a fiscal crisis. Once you are frozen out of the market, it means you have to go to [the EU] as bonds mature to replace them with cheaper finance," he says.
If such a course of action becomes necessary, it will once again add to the bill that Europe – mainly Germany – will have to foot. The total cost of country bailouts to date has been €485.5 bn (€240bn for Greece, €78bn for Portugal, €67.5bn for Ireland and now the €100bn for Spain).
Over and above, the ECB has spent several more hundred billion euros buying up the sovereign bonds of the strugglers. It has also made about €1 trillion available to shore up Europe's weak banks through the Long-Term Refinancing Operation after they went into credit-crunch mode last year.
To add to this bill of more than €2 trillion, there is the prospect of a bailout for Italy (see panel), smaller ones for Cyprus and possibly Slovenia, and possible second bailouts for Portugal and Ireland. And Greece might leave the eurozone – an event regarded as extremely unlikely or probable depending on who is forecasting.
This would directly hit the ECB (mainly Germany) with hundreds of billions of euros in liabilities from cash transfers with Greece, not to mention the unquantifiable knock-on effects to neighbouring countries.
All of this money is loans which must be paid back, but it is the strong countries (yes, mainly Germany) that will be left with the liabilities if this proves impossible.
One important question is whether we reach the point where Europe can no longer put any more money in the kitty. Some observers are already saying that the next step will be a massive intervention from the Americans, most likely with other countries riding alongside.
Frances Hudson, global thematic strategist at Standard Life Investments, says this ignores the fact that the US is heading for bleak times itself. The country is due next January to reverse all of former President Bush's temporary tax-cutting stimulus and cut $1.2tn (£774bn) from public spending.
Gabriel Sterne adds that America would not 'gift' Europe a huge tranche of money anyway. "You are more likely to see the ECB taking stronger action [to buy sovereign bonds]," he says. "Their firepower has been really held back. The question is whether there is a tolerance within Northern European constituencies for such a radical solution."
In theory, he says there is no limit to how many euros the ECB could print for such interventions. The question is how much Germany and allies like Austria and Finland would approve. Sterne adds that the common assumption of Germans being worried about inflation due to pre-and post-war experiences is overdone. More than that, he says, they are worried about the size of the liability.
Whatever the merits of such ECB action, the talk around solutions has been elsewhere of late. Last week European Commission President Jose Manuel Barroso called for a full banking union in the EU. This idea would involve all of Europe's large banks coming under centralised regulation and agreeing to a common insurance fund. They would be jointly liable for all the major banks in the region – this would, for example, have bailed out the Spanish banks rather than adding debt to the country's finances. Barroso believes such a system could be set up within a year.
David Cameron, however, indicated any banking union ought to be within the eurozone and not the EU as a whole – while Angela Merkel poured cold water on it by saying it would require changes to treaties.
Frances Hudson says that increasing the integration of Europe's banks should set off alarm bells. "It contradicts the whole ethos of what we've been trying to do post-financial crisis by making the big banks inextricably linked. It increases systemic risk." She says such a move would further isolate the British from Europe, but the alternative would be worse. Banks like HSBC and Standard Chartered, with heavy interests beyond Europe, would possibly switch headquarters rather than tie themselves to Brussels.
Dr Richard Reid, a Scots-born chief economist at the International Centre for Financial Regulation, says talk about a banking union is premature. "It's an attempt by the Commission to forward a very traditional Brussels agenda for deeper and broader federalism," he says. "The Germans feel they are being asked to fund a lot of risky operations without anything like what they would regard as significant progress over the mechanisms by which you monitor and control the national budgets of other countries - [And] there will be a tremendous resistance to the speed that Barroso is talking about."
If so, this would put them in the same category as Eurobonds. That notion of making the eurozone's members jointly liable for one another's debts receives more German opposition than almost any other solution. Dr Reid argues that in any case, none of these measures could come soon enough to help in the near term. As well as increased ECB intervention, he points to last Thursday's Mansion House announcement from Bank of England Governor Mervyn King – to provide lending to the economy through cheap loans to the banks – as the shape of things to come.
He foresees more quantitative easing, possibly through directly buying corporate bonds or making money available to development agencies and organisations like the Technology Strategy Board. He also believes solvent governments like the UK will soften austerity targets to encourage more growth.
This buffet of options will be served at the G20 meeting in Mexico this week and then at the European summit at the end of the month, after which policymakers are promising a big-ticket announcement. First, though, all eyes will be on the results of the Greek election. And whatever the outcome, the markets look unlikely to sit on their hands. In the slow calamity of the eurozone, the next few days may yet be among the most dramatic yet.
THE ITALIAN QUESTION
IF Italy found comfort in recent days, it was only that the markets were attacking Spanish debt harder than her own. This state of affairs may not last with Austrian finance minister Maria Fekter last week becoming the latest to suggest Italy might need a bailout.
Its problems are quite different to those of Spain. A report last week by Citigroup summed up the market's fears: "While we welcome the initiatives as important steps to improve Italy's growth outlook and fiscal position over the long-term, we believe the measures are unlikely to solve Italy's massive public-debt problem any time soon. Furthermore, the austerity measures are likely to deepen the recession in Italy in the near-term, which probably will lead to a clear failure of the government deficit targets -
"A significant further rise in yields, probably caused by an escalation of the sovereign debt crisis, would deepen and extend the recession and accelerate the rise in the debt/GDP ratio, triggering a worsening vicious circle that probably would leave Italy needing outside help at some point."