First, there is considerable daylight between what Germany wants and what the EU or the eurozone can agree to. Germany wants a new treaty with binding constraints. A new treaty requires all 27 countries to sign on because every country has a veto. A number of EU countries that are not in the eurozone lack enthusiasm for this idea. It is unclear if European law contemplates a treaty that leaves out a number of members. There could be a eurozne-only agreement, but not a treaty. It is hard to see how the leaders can emerge on Saturday with anything like what Merkel wants.
Second, there is little reason to believe that there is anything that can persuade the Bundesbank to reverse its position on rescuing Italy and Spain. While Draghi has made hopeful noises, the president of the Bundesbank, Jens Weidmann, has not. His position is that this is a matter for the EU to solve via eurobonds, which Merkel has ruled out. Draghi cannot rescue Italy and Spain without the Bundesbank’s consent.
It will be interesting to see how the leaders, who are staring into the abyss, can construct a communique that will obscure the summit’s failure.
Many European leaders have said that a failure to rescue Italy and Spain will lead to catastrophe. But standing in their way is Germany, which won’t agree to guarantee other countries’ debt, and the Bundesbank, which will not allow the Bundesbank to become the eurozone’s bond buyer of last resort.
Without either eurobonds or an ECB rescue, Italy and Spain are doomed.
In the event of their default and/or redenomination, the rest of Europe will have to recapitalize their banks. This will place strains on everyone, especially France and Germany. In the end, I would expect the ECB to capitulate and embark upon an unprecedented campaign of quantitative easing.
Should it fail to capitulate (soon), the outlook for the eurozone is dire. Those of us outside the eurozone (UK, Canada, US, Australia, Japan) will be able to lean against the deflationary forces blowing over from Europe.
The major economy most at risk now, besides Italy and Spain, is France. France may lose its AAA, will have to bailout its banks, and will have to remain credible in the bond market. This will force a level of austerity that could lead to civil unrest.