Hugo Dixon

The credit crisis burst into the open five years ago. The euro crisis has been rumbling for over two years. The term “crisis” isn’t just on everybody’s lips in finance. Wherever one turns – politics, business, medicine, ecology, psychology, in fact virtually every field of human activity – people talk about crises. But what are they, how do they develop and what can people do to change their course?

The first thing to say is that a crisis is not just a bad situation. When the word is used that way, it is devalued. The etymology is from the ancient Greek: krisis, or judgment. The Greek Orthodox Church uses the term when it talks about the Final Judgment – when sinners go to hell but the virtuous end up in heaven. The Chinese have a similar concept: the characters for crisis represent danger and opportunity.

A crisis is a point when people have to make rapid choices under extreme pressure, normally after something unhealthy has been exposed in a system. To use two other Greek words, one path can lead to chaos; another to catharsis or purification.

A crisis is certainly a test of character. It can be scary. Think of wars; environmental disasters that destroy civilisations of the sort charted in Jared Diamond’s book Collapse; mass unemployment; or individual depression that triggers suicide.

But the outcome can also be beneficial. This applies whether one is managing the aftermath of Lehman Brothers’ bankruptcy, the current euro crisis, the blow-up of an oil rig in the Gulf of Mexico or an individual’s mid-life crisis. Much depends on how the protagonists act.

Students of crises are fond of dividing them into phases. For example, Charles Kindleberger’s Manias, Panics, and Crashes identifies five phases of a financial crisis: an exogenous, normally positive, shock to the system; a bubble when people exaggerate the benefits of that shock; distress when some financiers realise that the game cannot last; the crash; and finally a depression.

While there is much to commend in Kindleberger’s system, it is too rigid to account for all crises in all fields. It also downplays the possibility that decision-makers can change the course of a crisis. A more flexible scheme that leaves space for human agency to affect how events turn out has two just phases: the bubble and the crash.

The bubble is typically characterised by mania and denial. Things are going well – or, at least, appear to be. Feedback loops end up magnifying confidence. In corporations or politics, bosses surround themselves with lackeys who tell them how brilliant they are. In finance, leverage plays a big part.

This is not healthy. Manic individuals don’t know their limitations and end up taking excessive risks – whether on a personal level or in managing an organisation or an entire economy. As the ancient Greeks said, hubris comes before nemesis.

But before that, there is denial. People do not wish to recognise that there is a fundamental sickness in a system, especially when they are doing so well. For example, back in 2007 at the World Economic Forum in Davos, the greed was palpable. Market participants had such a strong interest in keeping the game going that they turned a blind eye to the unsustainable buildup of leverage.

The ethical imperative in this phase is to burst the bubble before it gets too big. That, in turn, means both being able to spot a bubble and having the courage to stop the party before it gets out of hand. Neither is easy. It’s hard to recognise a sickness given that there is usually some ideology which explains away the mania as a new normal. The few naysayers can be ridiculed by those who benefit from the continuation of the status quo.

What’s more, politicians, business leaders and investors rarely have long-term horizons. So even if they have an inkling that things aren’t sustainable, they may still have an incentive to prolong the bubble.

The crash, by contrast, is characterised by panic and scapegoating. People fear that the system could collapse. Negative feedback loops are in operation: the loss of confidence breeds further losses in confidence. This is apparent on an individual level as much as a macro one.

Events move extremely fast and decisions have to be taken rapidly. Witness the succession of weekend crisis meetings after Lehman went bust – or the endless euro crisis summits. The key challenge is to take effective decisions that avoid vicious spirals while not embracing short-term fixes that fail to address the fundamental issues. With the euro crisis:, for example, it is important to improve competitiveness with structural reforms not just rely on liquidity injections from the European Central Bank.

In this phase, there is no denial that there is a problem. But there is often no agreement over what has gone wrong. Protagonists are reluctant to accept their share of responsibility but, instead, seek to blame others. Such scapegoating, though, prevents people from reforming a system fundamentally so that similar crises don’t recur.

Crises will always be a feature of life. The best that humanity can do is to make sure it doesn’t repeat the same ones. And the main way to evolve – both during a bubble and after a crash – is to strive to be honest about what is sick in a system. That way, crises won’t go to waste.

Solving the euro crisis is a race against time. Can peripheral economies reform before the people buckle under the pressure of austerity and pull the rug from their politicians? After two months of optimism triggered by the European Central Bank’s plans to buy government bonds, investors got a touch of jitters last week.

The best current fear gauge is the Spanish 10-year government bond yield. After peaking at 7.64 percent in late July, it fell to 5.65 percent in early September. It then poked its head above 6 percent in the middle of last week because there were large demonstrations against austerity; because Mariano Rajoy’s government was dragging its heels over asking for help from the ECB; and because the prime minister of Catalonia, one of Spain’s largest and richest regions, said he would call a referendum on independence.

But by the end of the week, the yield was just below 6 percent again. That’s mainly because Rajoy came up with a new budget which contains further doses of austerity. The move prepares the way for Madrid to ask for the ECB to buy its bonds and so drive down its borrowing costs.

Rajoy didn’t want to be seen to be told to do anything by his euro partners. Hence, this elaborate dance – where he has now done what he knew he would have been told to do but can claim it was his choice. It’s hard to believe that anybody is fooled by this subterfuge; indeed, from investors’ perspective, it looks childish. But, at least the show is on the road again: the government has had the guts to press ahead with reform despite the immense unpopularity of the measures.

The question is whether Madrid and other governments in Lisbon, Dublin, Rome and Athens can keep up the reforms long enough to restore their economies to health. That, in turn, depends on three factors: how much farther they have to travel; how unruly their people are going to get; and how much help they will receive from their partners.

Economic health requires both that fiscal deficits are eliminated and that competitiveness is restored. The peripheral economies have made some progress on both fronts. But shrinking economies makes it hard to balance their budgets while fiscal squeezes undermine growth. The austerity vicious spiral is still whirring away.

That’s why Spain is unlikely to hit its target of cutting its deficit to 4.5 percent of GDP next year. It can get there only on the optimistic assumption that the economy will shrink by just 0.5 percent in 2013. The same could be said of France, not yet a full member of the periphery, whose budget unveiled last Friday calls for a deficit of 3 percent of GDP next year. Paris is assuming 0.8 percent growth. The French prime minister describes the projection as “realistic and ambitious”. Just ambitious would have been a more accurate description.

Meanwhile, restoring competitiveness is painful because it involves cutting people’s pay. Ireland and Spain have made good progress, covering respectively 80 percent and 50 percent of what they needed to achieve by the end of last year, according to a report last week by Open Europe, a British think-tank. Portugal and Greece have done less well.

Current account deficits paint a similar picture. Spain’s had shrunk to 3.5 percent of GDP last year while Ireland actually had a small surplus. Portugal, though, had a deficit of 6.4 percent of GDP and Greece was struggling with one of 9.8 percent.

Big falls in pay are forecast for the deficit countries over the next two years by Eurostat. It sees unit labour costs dropping 4.7 percent in Spain between end-2011 and end-2013; 3.8 percent in Portugal; and 9.5 percent in Greece. If that happens, competitiveness could be restored. Citigroup forecasts that Spain and Portugal will have current account surpluses next year while Greece’s deficit will have shrunk to 2.8 percent.

The snag is that such pay cuts – especially when combined with higher taxes and rising unemployment – provoke howls of outrage from the population. Short of leaving the single currency and devaluing, the only other medicine for improving competitiveness is so-called fiscal devaluation. This involves cutting the social security contributions paid by employers and, in return, putting up other taxes.

Germany succeeded in pushing through such a fiscal devaluation in 2007. But that just made it more competitive vis-a-vis the weaker euro zone economies. More recently, Spain did a mini fiscal devaluation. But the most ambitious attempt, by Portugal, provoked such a massive backlash earlier this month that the government backed down.

Help from abroad is the main way of easing the pain of adjustment. The ECB’s promised bond-buying plan is the most dramatic example. But solidarity has its limits. There has been a backlash in the German media over the central bank’s plan. Meanwhile, Berlin has been trying to persuade Madrid not to ask for help. The German finance minister also clubbed together with his Dutch and Finnish counterparts last week, proposing rules that will make it harder for Spain to shift the cost of bailing out its banks onto the euro zone.

The consequences of a breakup of the euro zone would be so ghastly for both the periphery and the core that they will probably pull through what looks like it is going to be at least another year of hell. But the risks have certainly not vanished.

European integration tends to advance first with squabbling then with fudge. Every country has its national interest to defend. Some politicians appreciate the need to create a strong bloc that can compete effectively with the United States, China and other powers. But that imperative typically plays second fiddle to more parochial concerns with the result that time is lost and suboptimal solutions are chosen.

Amidst the europhoria unleashed by the European Central Bank’s bond-buying plan, it is easy to miss the immense challenges posed by two complex dossiers that have just landed on leaders’ desks: the proposed EADS/BAE merger; and a planned single banking supervisor.

Look first at the plan to create a defence and aerospace giant to rival America’s Boeing. This has been under discussion since at least 1997 when the UK’s Tony Blair, France’s Jacques Chirac and Germany’s Helmut Kohl called on the industry to unify in the face of U.S. competition. London, Paris and Berlin are the key players in this game because they have the major assets.

Since 1997, progress has been patchy. Airbus, previously an awkward Franco-German-British consortium, was gradually turned into a proper company wholly owned by EADS – and EADS itself was created by the merger of France’s Aerospatiale and Germany’s Dasa. But Paris and Berlin insisted on a dysfunctional governance structure designed to balance their respective power rather than promote an effective organisation and EADS’ early years were bedevilled by scandal. What’s more, BAE opted to stay out of European integration, instead merging with Britain’s Marconi and going on a U.S. acquisition spree.

The cost of developing new products, such as fighter aeroplanes, is huge: Europe’s last major initiative in this area, the Eurofighter, was developed through another suboptimal consortium. If Europe can’t get its act together, BAE may eventually find itself swept into the arms of a large U.S. group and governments may ultimately be forced to buy American. Being dependent on even such a close ally should not be their first choice. So there is a strategic benefit in creating a streamlined European defence and aerospace group.

The best solution would be to merge EADS and BAE, and run the new group on commercial lines. The politicians would abandon their right to decide who would manage it or where its factories and research centres would be located. The most important interests of France, Germany and Britain could be protected by ring-fencing their secrets and giving each government a veto over any takeover of the group.

To be fair, the planned merger – which leaked last week – takes a big step in this direction. A complex shareholder pact, which balances French and German interests in EADS, would be scrapped. The private shareholders involved in that pact – France’s Lagardere and Germany’s Daimler – are also expected to sell out eventually.

The snag is that Paris would keep a stake of around 9 percent, potentially letting it pull the strings from behind the scenes. Both London and Berlin seem worried about that. Germany may also be queasy about a plan, so far unannounced, to locate the merged company’s defence HQ in the UK and its civilian aerospace HQ in France.

Even if these circles can be squared, Washington may cause trouble. BAE has been able to acquire a substantial U.S. defence business because of the special military relationship between London and Washington. If the U.S. administration concludes that the new group is effectively controlled by Paris, with which relations are cooler, it may put so many controls on its U.S. business that it becomes commercially unattractive.

It would be better if France sold out of the combined group and depoliticised it entirely. But that doesn’t seem on the cards.

Now look at the euro zone’s plans for a banking supervisor, for which the European Commission unveiled a blueprint last week. Again, the idea is sensible, albeit not a silver bullet. A centralised supervisor based on the ECB might be able to clean up the banking cesspit in places like Greece, Spain and Ireland. This could pave the way for struggling lenders to be recapitalised with euro zone money rather than national money. And that, in turn, could play a role in diminishing the euro crisis.

There are, though, at least two major problems. First, Berlin doesn’t want its local savings banks supervised by the ECB. This is largely a matter of protecting vested interests, as the Sparkassen are closely linked to local politicians. But it is precisely such incestuous relationships that caused mayhem with Spain’s savings banks, the cajas. It would set a bad precedent if Germany could cut a special deal for itself merely because it is the biggest boy in the euro class.

Second, how will the interests of the 10 countries that are part of the European Union but don’t use the single currency be protected as the euro zone moves ahead with banking integration? This is of particular concern for the UK, Europe’s financial capital. Under the European Commission’s plans, the 17 members of the euro would caucus together to decide on matters like technical rules for banking which cover the entire EU. London could therefore find itself perpetually outvoted.

There may be ways of squaring these circles. But, as with defence integration, politicians will need to keep their eye on the big picture even as they defend their legitimate national interests. That hasn’t always been their forte.

The European Central Bank’s bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone’s two large problem children and, with them, the single currency.

Mario Draghi’s promise in late July to do “whatever it takes” to preserve the euro has already had a dramatic impact on Madrid’s and Rome’s borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.

Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank’s financial firepower is theoretically unlimited, whereas the euro zone governments’ own bailout funds do not have enough money to rescue both Spain and Italy.

But the new type of intervention, christened “Outright Monetary Transactions”, has three important limitations.

First, the ECB will only buy a country’s bonds if its government agrees to a bailout programme with the euro zone, and sticks to “strict and effective” conditions detailed in such a deal. Second, the central bank will focus its purchases on bonds with a maturity of one to three years. Finally, Draghi has not specified how much he wants to drive down Madrid’s and Rome’s borrowing costs.

This fine print makes sense. But it also means that there is no free lunch. While the ECB seems unlikely to dream up new economic reforms for Spain and Italy, it will probably want their governments to put more precise time frames around what they are already supposed to be doing. The involvement of the International Monetary Fund, which has a somewhat unfounded reputation as a bogeyman, will also be sought. No wonder neither Spain’s Mariano Rajoy nor Italy’s Mario Monti is rushing to take advantage of the scheme.

Meanwhile, the ECB’s focus on short-term bonds means that Madrid and Rome would have to find some other way of issuing long-term debt – which accounts for 66 percent and 62 percent of outstanding debt respectively. If they lost access to the markets, the zone’s bailout funds would have to ride to the rescue. But they still wouldn’t have enough money for both countries.

What’s more, Spain’s and Italy’s borrowing costs are still too high for comfort. The ECB’s main justification for bond-buying is that investors are unfairly punishing them because of fears that the euro will break up. But it also recognises that the spread between their bond yields and Germany’s 1.5 percent 10-year borrowing costs is only partly due to such “convertibility risk”. It is also because of bad economic policies.

While there aren’t any scientific measures of convertibility risk, it seems like the bulk of it has disappeared since Draghi’s comments in late July. A reasonable guesstimate is that the risk of euro breakup might still be inflating Spanish yields by 1 percentage point and Italian ones by perhaps 0.75 percentage points. If the ECB used those numbers to guide its bond-buying programme, 10-year borrowing costs would drop to 4.7 percent and 4.4 percent respectively. To fall further, the countries would need to take more action themselves.

Although investors are currently relatively bullish about Spain and Italy, they are notoriously fickle. Rajoy and Monti should remember how the good mood, engineered at the start of the year by the ECB’s 1 trillion euros of cheap long-term loans to the zone’s banks, vanished with the spring. What’s more, both are facing tougher political challenges than they did at the start of the year when they were enjoying their honeymoons as new prime ministers. Each of their economies has declined this year and will continue to do so next year – shrinking roughly 5 percent over the two-year period, according to Citigroup.

For all these reasons, it is vital that Rajoy and Monti don’t dawdle. Assuming the German constitutional court this week backs the creation of the European Stability Mechanism, the zone’s permanent bailout fund, the Spanish prime minister should apply immediately for a programme.

Italy, a rich country, should still be able to avoid a bailout. But to do so it needs to cut its public debt, ideally with a vigorous privatisation programme and the creation of a wealth tax. With elections due next April and no guarantee that an effective government can be formed thereafter, there is only a tiny window for action. Monti’s technocratic government needs to jump through it.

The ECB has put its credibility on the line with its new bond-buying plan. Germany’s central bank, the Bundesbank, has attacked it on the grounds that it has come close to breaking treaty provisions banning the ECB from bailing out governments. For now, Draghi can withstand the criticism, as long as Angela Merkel keeps backing him. But if Rajoy and Monti don’t move fast, the ECB’s magic will wear off. And if its medicine then fails, it will be hard to conjure up the political will for an even more powerful concoction.

Can Super Mario save the euro? Mario Draghi said last Thursday that the European Central Bank’s job is to stop sovereign bond yields rising if these increases are caused by fears of a euro break-up. While this represents a sea-change in the ECB president’s thinking, it risks sowing dissension within his ranks. He will struggle to come up with the right tools to achieve his goals.

Draghi seemingly stared into the abyss and had a fright. Spanish 10-year bond yields shot up to 7.6 percent on July 24 while Italian ones rose to 6.6 percent. The high borrowing costs are not simply a reflection of the two countries’ high debts and struggling economies. Investors also fear “convertibility risk” – or the possibility that the euro will break up and they will get repaid in devalued pesetas and liras.

The central banker’s statement that dealing with convertibility risk is part of the ECB’s mandate is therefore highly significant. He rammed home his message, saying: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Markets responded swiftly. Spain’s borrowing costs fell to 6.8 percent, while Italy’s dropped just below six percent. But these yields have to drop below five percent – and stay there – before confidence in the euro project will return. What’s more, it’s unclear what Draghi will actually do.

One possibility, immediately latched onto by investors, is that the ECB will relaunch its programme of buying government bonds in the market. But such an operation would be tough to calibrate. If the ECB was prepared to do whatever it took to drive yields below a certain level, the pressure would certainly be off Spain and Italy. But politicians might then stop reforming their economies. When the ECB bought Italian bonds last summer, that’s precisely what happened.

That’s why Germany’s Bundesbank, which has a powerful voice within the ECB but no veto over its actions, is opposed to bond-buying – potentially setting the stage for a stormy meeting when the ECB governing council meets to discuss what to do on Aug. 2. It’s not yet clear how big a spoke the German central bank will be able to put into Draghi’s plans.

On the other hand, if the ECB made its support conditional on good behaviour, investors might not be reassured. Their anxiety would be heightened if central bank bond-buying pushed private creditors down the pecking order. That’s what happened when Greece’s debt was restructured earlier this year: private bondholders suffered big losses while the ECB theoretically stands to make a profit. A half-hearted bond-buying programme might therefore simply encourage investors to dump their holdings on the ECB while having no lasting effect on Spain’s and Italy’s borrowing costs.

Draghi may think that the two countries’ current leaders – Spain’s Mariano Rajoy and Italy’s Mario Monti – are more serious about reform than their predecessors Jose Luis Rodriguez Zapatero and Silvio Berlusconi. But even the new leaders have shown signs of losing momentum. Rajoy’s latest spurt of action – further budget-tightening and a plan to recapitalise the country’s struggling banks – only occurred because his back was to the wall. In Italy, meanwhile, Monti says he will stop being prime minister next spring. It’s not clear whether his successor will be committed to reform.

For these reasons, Draghi seems reluctant for the ECB just to buy bonds on its own. Rather, he seems to want to do so in combination with the euro zone’s bailout funds, which have the ability to buy bonds directly from governments – something the ECB is banned from doing. One advantage is that Madrid and Rome would have to sign memorandums of understanding setting out their reform plans in order to access the bailout funds. It would then be easier to hold them to their commitments.

A further idea, reported by Reuters, could help deal with private creditors being pushed down the pecking order. Policymakers are working on a “last chance” option to cut Athens’ debt – involving the ECB taking a haircut on its Greek bond holdings. If that happened, investors would worry less about being unfairly treated if Spain or Italy ever needed to restructure their debts. They might then not view bond-buying as the perfect chance to offload their holdings onto the public sector.

The two-pronged approach is preferable to the ECB buying bonds solo. But it would still put the central bank in the front line of rescuing governments. A better approach would be to scale up the euro zone’s bailout funds and get them to do the entire job of lending to Spain and Italy, if they need help. This could be achieved by letting the soon-to-be-created European Stability Mechanism (ESM) borrow money from the ECB.

Draghi should prefer lending to the ESM than buying Spanish or Italian bonds because, if either country got into trouble, the bailout fund not the ECB would take the first losses. Unfortunately, the ECB said last year that extending loans to the ESM would contravene the Maastricht Treaty – a position Draghi himself repeated after he took over as president, even though there are plenty of lawyers who think the opposite.

Super Mario is now warming to the idea of lending to the ESM, according to Bloomberg, even though that’s not part of his immediate plan. If Draghi does this, he’ll have to find a way to eat his words without losing credibility. If not, he will have to rely on second-best options with all their drawbacks. Mind you, it’s the job of super heroes to get out of tight spots.

The euro crisis is to a great extent a confidence crisis. Sure, there are big underlying problems such as excessive debt and lack of competitiveness in the peripheral economies. But these can be addressed and, to some extent, this is happening already. Meanwhile, a quick fix for the confidence crisis is needed.

The harsh medicine of reform is required but is undermining confidence on multiple levels. Businesses, bankers, ordinary citizens and politicians are losing faith in both the immediate economic future and the whole single-currency project. That is creating interconnected vicious spirals.

The twin epicentres of the crisis are Spain and Italy. The boost they received from last month’s euro zone summit has been more than wiped out. Spanish 10-year bond yields equalled their euro-era record of 7.3 percent on July 20; Italy’s had also rebounded to a slightly less terrifying but still worrying 6.2 percent.

As ever, the explanation is that the summiteers came up with only a partial solution and even that was hedged with caveats. Although the euro zone will probably inject capital into Spain’s bust banks, relieving Madrid of the cost of doing so, the path will be tortuous. Meanwhile, a scheme which could help Italy finance its debt will come with strings attached – and there still isn’t enough money in the euro zone’s bailout fund to do this for more than a short time.

The two countries’ high bond yields aren’t just a thermometer of how sick they are. They push up the cost of capital for everybody in Spain and Italy, while sowing doubts about whether the whole show can be kept on the road. Capital flight continues at an alarming rate, especially in Spain. The so-called Target 2 imbalances, which measure the credits and debits of national central banks within the euro zone, are a good proxy for this. Spain’s Target 2 debt had grown to 408 billion euros at the end of June, up from 303 billion only two months earlier. The Italian one was roughly stable but still high at 272 billion euros.

The loss of confidence is harming the economy. Spain’s GDP is expected to shrink by 2.1 percent this year and a further 3.1 percent next year, according to Citigroup, one of the more pessimistic forecasters. The prospects for Italy are not much better: a predicted 2.6 percent decline this year followed by 2 percent next year.

Shrinking economies are, in turn, pushing up debt/GDP ratios. Citigroup expects Spain’s to jump from 69 percent at the end of last year to 101 percent at the end of 2013, in part because of the cost of bailing out its banks, while Italy’s will shoot up from 120 percent to 135 percent. These eye-popping numbers then reinforce anxiety in the markets.

All of this is having a corrosive effect on the political landscape. In Italy, the situation is especially precarious as Mario Monti, the technocratic prime minister, has repeatedly said he will resign after next spring’s elections. The centre-left Democratic Party, which is leading in the opinion polls, is still committed to the euro. But the second and third most popular political groups – the Five Star movement led by comedian Beppe Grillo, and Silvio Berlusconi’s PdL – are either outright eurosceptics or toying with becoming so.

The situation is slightly better in Spain because Mariano Rajoy has a solid majority and doesn’t officially have to face the electorate for three and a half years. But hundreds of thousands of demonstrators took to the streets last week to protest against the latest austerity measures. Pundits are starting to speculate that Rajoy may not last his full term. And if the Italian and Spanish governments can’t carry their people with them along the reform path, the fear is that Germany may no longer support them.

High borrowing costs, capital flight, and economic and political weakness: to escape this vortex, the immediate priority is to get Spain’s and Italy’s bond yields back down. The goal should be to cut borrowing costs below 5 percent – a level that would no longer be that worrying. While most of the ways of doing this have been vetoed by Germany, at least two haven’t.

One is to leverage up the European Stabilisation Mechanism, the region’s bailout fund, so that it has enough money to fund both Madrid and Rome. Neither Germany nor the European Central Bank want to let the ESM borrow money from the ECB itself. But what about lifting the cap on how much it can borrow from the market?

Another option would be for the core countries, led by Germany and France, to subsidise Spain’s and Italy’s interest rates directly – giving back to the southern Europeans part of the benefit they are enjoying from their own extremely low borrowing costs. If they agreed to close half the gap between the core and the periphery, such a scheme would cost around 75 billion euros over seven years, according to a Breakingviews’ calculation. An interest-rate subsidy would also give markets the confidence that Madrid and Rome would be able to finance their debts and so could further lower their borrowing costs.

There would, of course, have to be conditions. In Italy, Monti needs to embark on a second wave of reforms. In particular, he should launch a mass multi-year privatisation programme and a big one-off wealth tax to cut Italy’s debt. But after Spain’s recent plan to clean up its banking sector and further tighten its belt, there is little more to be asked of it.

Germany is right to insist on reforms. But it should balance the stick with a bigger carrot. Otherwise, the single currency from which it benefits so much could collapse.

Cuando despertó, el dinosaurio todavía estaba allí. “Upon waking, the dinosaur was still there.”

This extremely short story by Guatemalan writer Augusto Monterroso sums up the state of play on the euro crisis. Last week’s summit took important steps to stop the immediate panic. But the big economies of Italy and Spain are shrinking and there is no agreed long-term vision for the zone. In other words, the crisis is still there.

The summit’s decisions are not to be sniffed at. The agreement that the euro zone’s bailout fund should, in time, be able to recapitalise banks directly rather than via national governments will help break the so-called doom loop binding troubled lenders and troubled governments. That is a shot in the arm for both Spain and Ireland. Meanwhile, unleashing the bailout fund to stabilise sovereign bond markets could stop Rome’s and Madrid’s bond yields rising to unsustainable levels.

Insofar as this restores investors’ confidence, Spain and Italy could avoid the need to obtain a full bailout or restructure their debts. And Ireland, which is in a full bailout programme, could exit that and fund itself in the market again.

The immediate market reaction on Friday was positive. The yield on 10-year bonds fell: for Spain from 6.9 percent to 6.3 percent, for Italy from 6.2 percent to 5.8 percent and for Ireland from 7.1 percent to 6.4 percent. But these rates are still high. And, with the exception of Ireland, Friday’s market movements only take prices back to where they were in May.

What’s more, as the details of Friday’s agreement are picked over, some of the market euphoria may well fade. After all, Germany, the zone’s paymaster, hasn’t written a blank cheque.

Take the bank recapitalisation plan. Madrid is planning to inject up to 100 billion euros into its banks and Dublin has already sunk 64 billion euros into its lenders. The big question is whether the euro zone will reimburse them the full amount invested, given that the stakes in the banks aren’t worth as much. That seems unlikely. But if the full sum isn’t paid, the debt relief for Spain and Ireland may not be as big as some are hoping.

Or look at the market stabilisation mechanism. The euro zone bailout fund’s resources are limited, so it might not be able to keep Italian and Spanish borrowing costs down in the long run. What’s more, to access this mechanism, a country would have to agree to a memorandum of understanding setting out its policy commitments to reform its economy. This means that there will still be some stigma attached to the scheme – which probably explains why Rome and Madrid aren’t rushing to sign up.

To point out that Germany’s Angela Merkel hasn’t agreed a blank cheque is not to criticise the summit compromise. It is essential that Italy’s Mario Monti and Spain’s Mariano Rajoy take further measures to restore their countries’ competitiveness. A second wave of reforms is needed, but both prime ministers have lost momentum in recent months. Money for nothing will take away pressure to do more.

However, the continued uncertainty about exactly how bank bailouts and market stabilisation will work means that the summit did not produce a neat package. As the loose ends are tied up, there could be further wrangling that unnerves investors.

Meanwhile, GDP in both Italy and Spain are continuing to shrink. This means that they won’t hit their deficit reduction targets and that their debts and unemployment will rise further. The summit’s 120 billion euro growth pact isn’t likely to move the needle. More may need to be done to shore up growth. One obvious suggestion would be still looser monetary policy from the European Central Bank.

Recession also has political consequences, especially in Italy, where elections are due next spring at the latest. Both Beppe Grillo, a comedian whose populist Cinque Stelle movement has come from virtually nowhere to 20 percent in the opinion polls in recent months, and Silvio Berlusconi, the former prime minister, are playing the eurosceptic card. In the circumstances, Monti’s technocratic government will struggle to gain political support for any more reforms. Investors and Italy’s euro partners will, in turn, worry about what comes after him.

The euro zone leaders also agreed, in principle, on the first step towards a long-term vision for the region: the creation of a single banking supervisor “involving the ECB”. If this cleans up the mess in large parts of the European financial system, it will be good. But some countries will not wish to surrender control over their banks to a centralised authority and so it is quite possible that some messy fudge will emerge.

If the question of a single banking supervisor is likely to be subject to future disputes, even more disagreement can be expected over whether there should be a full political and fiscal union. Some countries like Germany want much more common decision making, but others fear the loss of sovereignty. Meanwhile, many weaker nations want to pool their debts – an idea rightly rejected by Merkel.

Europe’s people are not ready for full political union. So the best solution would be to keep the loss of sovereignty and debt-sharing down to the minimum. But the summit kicked these big issues into touch.

The dinosaur is less terrifying than it was a few weeks ago. But it is still there.

Some European policymakers are talking about a “banking union” for the euro zone as if it was around the corner. Jose Manuel Barroso, the European Commission president, for example, told the Financial Times last week that such a union – which would involve euro-wide supervision, bailouts and deposit insurance for the banking industry – could be achieved next year.

But this is not remotely likely. Parts of the zone’s banking industry are so rotten that taxpayers elsewhere can’t reasonably be asked to bear the burden of bailing them out. A massive cleanup is required first. The crisis in Greece, Spain and other countries may provide the impetus. But even then, as Germany suggests, banking union should proceed in stages.

The appeal of a euro zone banking union is understandable. Governments and lenders are currently roped together in what has been dubbed the sovereign-bank doom loop. Weak banks – for example those in Spain, Ireland and Cyprus – can drag down their governments when they need a bailout. Equally, weak governments, such as Greece’s, can drag down their banks when those are stuffed with their own sovereigns’ bonds. By shifting responsibility for bailouts to the euro zone as a whole, the loop could be cut. Or, at least, that is the hope.

The snag is that banks and their governments are entangled in a tight incestuous relationship. Some of Spain’s cajas, for example, made dubious loans to their directors, as well as financing politicians’ pet projects. And the ex-chairman of Bankia, which has required the mother of all bailouts, was a former finance minister. Conflicts of interest have also been rife in Ireland, Cyprus and Greece. Even supposedly virtuous Germany has suffered from incompetent Landesbanken, controlled by regional governments, whose boards are filled with political appointees.

Bank boards were often useless or worse. But the national supervisors who should have spotted the problems were not much better. And Europe’s initial attempts at cross-border banking supervision have been pathetic. A European-wide stress test in 2010 didn’t even bother to examine Anglo Irish, a cesspit of bad property loans which virtually bankrupted Dublin. Another test in July 2011 concluded that Spain’s banks were only 1.6 billion euros short of capital. Then another last October bumped the number up to 26 billion euros – but didn’t stress the lenders’ property loans. Finally, last weekend’s bailout came up with a hopefully more realistic figure: up to 100 billion euros.

Governments have given the European Banking Authority (EBA) inadequate authority to overrule national supervisors. Meanwhile, the domestic authorities always have an incentive to downplay the capital needs of their banks. So long as lenders are pronounced solvent, they can get liquidity from the European Central Bank. That way, governments can delay putting in any of their own money to bail out their domestic lenders.

Part of the “doom loop” involves banks stocking up on sovereign debt. That link has grown tighter in Italy and Spain in recent months as foreigners have stopped buying bonds, leaving domestic lenders to step into the breach. They got the money from the ECB. If governments really surrendered control of their banks to a tough supranational agency, it would be harder to engineer such a money-go-round.

Yet another problem is that governments are reluctant to inflict losses on bondholders. In Bankia’s case, there were an estimated 12 billion euros of subordinated debt and 8 billion euros of senior debt – or 20 billion euros in total. These have not suffered losses as part of the bailout. But unless there are haircuts for a bank’s own bondholders, is it reasonable to ask the taxpayers of a foreign country to fork out cash to bail out banks and their depositors?

All this means that for banking union to work effectively, there needs to be effective supervision as well as a system to bail in bondholders. Everyone agrees on this. The real debate is largely one of timing. The peripheral countries want a euro-wide system of bailouts and deposit insurance fast, as an answer to the current crisis. Germany is stressing the need to start with supervision.

Berlin is right that the clean-up has to come first. That may, of course, be accelerated by the crisis. Spain’s banking bailout gives the rest of the euro zone a golden opportunity to insist that its system of crony finance is swept away. The same goes for Cyprus, a haven for recycling dubious money from Russia and elsewhere, if it requires a bailout.

But the euro zone will also need to determine who will supervise banks. The EBA is a busted flush. So it would be best way to empower an institution that has credibility. The obvious candidate is the ECB – an idea Germany’s Angela Merkel backed last week. But even that could be problematic: giving the ECB responsibility for supervision as well as monetary policy would concentrate a huge amount of power in a single body. Even it might struggle to monitor banks over such a vast area.

Then, of course, a system for bailing in bondholders needs to be crafted. Although the European Commission this month proposed a plan, it is not supposed to kick in until 2018. Finally, there is the question of how governments in trouble will finance their debts if they can no longer lean on their banks. Nobody yet has a good answer to this.

The banking union train may be about to leave the station. But it will take years to reach its destination.

The euro zone crisis is a multi-dimensional game of chicken. There isn’t just a standoff between the zone’s core and its periphery; there is also one between the European Central Bank and the euro zone governments over who should rescue the single currency. In such games somebody usually blinks. But if nobody does, the consequences will be terrible.

The brinkmanship between the governments is over how much help the northerners, led by Germany, should give the southerners. The core is effectively threatening the peripheral countries with bankruptcy if they don’t cut their deficits and reform their economies. The periphery is saying that, if they collapse, so will the entire single currency which has been so beneficial to Germany’s economy. The game is being played out transparently in Greece and covertly in Spain.

But even if the core eventually decides to help the periphery, there is a struggle of whether the aid should come from governments or from the ECB. Politicians would like the central bank to do the heavy lifting to avoid having to confront taxpayers with an explicit bill. But the ECB doesn’t think it is its job to help governments, arguing that such support violates the Maastricht Treaty.

This standoff is making it hard to devise a Plan B to cope with what is now a clear and present danger: an explosion in the euro zone.

Look at the most immediate problem: what to do if the “jog” out of Greek bank accounts accelerates into a run. The ECB’s exposure to Greek banks is about 125 billion euros – through a combination of its normal liquidity operations and emergency liquidity assistance (ELA) provided by Greece’s central bank.

The Bundesbank, Germany’s hard-line central bank, says the eurosystem, the collection of national central banks, shouldn’t increase its risk level in Greece. Instead, it wants governments to guarantee any further liquidity injections. But the politicians don’t want to face that issue, at least until Greek voters have given a clear answer over whether they want to stay in the euro.

The snag is that the June 17 election may not provide a clear answer and that might provoke a bank run. At the moment, there isn’t a plan of how to respond. Would the ECB blink and authorise extra ELA – in which case it would look remarkably silly if Greece then quit the euro and the central bank faced massive extra losses on its exposure? Or would it shut off the tap – in which case cash withdrawals from Greek ATMs would have to be rationed, quite possibly provoking panics elsewhere?

The difficulty coming up with contingency plans goes beyond Greece. What, for example, should be done if bank runs do spread to other countries such as Spain and Italy? Mario Draghi, the ECB’s president, last week gave what might seem like a reassuring comment to the European Parliament, saying: “We have all the means to cope with this as far as solvent banks are concerned”. What he didn’t spell out, though, is how the ECB would react if there were runs on insolvent lenders.

There would probably be brinkmanship. The ECB would argue that it was the governments’ job to recapitalise their banks. The politicians would try to avoid injecting taxpayers’ money into their lenders, not least because the governments don’t have the cash. The ECB would then probably say the governments should borrow money from the European Stability Mechanism (ESM), the euro zone bailout fund.

The politicians might come up with inventive schemes, such as giving their banks IOUs which could then be swapped with their own national central banks for ELA. That fudge was used two years ago to recapitalise Ireland’s banks – and Spain was originally toying with a variation on the theme to shore up Bankia. But the ECB doesn’t like it, not least because ELA is supposed to be only temporary.

On the other hand, if neither side blinked, some banks could collapse – triggering runs even among solid ones.

Yet another weakness in the euro’s defences is what to do if investors refuse to buy Spanish and Italian government debt. Madrid, for one, wants the ECB to step in with massive purchases of its bonds through what is known as the securities markets programme. The central bank, though, thinks it should do this only to a limited extent and that if a government needs cash, the relief should come from the ESM, that is from the other governments.

The snag is that the bailout fund doesn’t have enough money to rescue both Madrid and Rome. That’s why France and other countries have argued that it should be allowed to borrow money from the ECB – back to the central bank again. But Draghi has rejected that idea, saying that it would constitute “monetary financing” – or bailing out governments by printing cash – which is forbidden by the Maastricht Treaty. Others argue that the legal position isn’t so clear.

Either way, another potential standoff is being set up. If Italy lost access to the markets and the ECB didn’t blink, then Rome would have to turn to extreme measures: force its citizens to buy bonds, suspend debt repayments or something else. That would be a pretty hairy moment, which might spell the end of the single currency.

Of course, all hell might not break loose. And, if it does, some clever compromises might be found. But multi-dimensional chicken certainly heightens the risks.

Greece needs to go to the brink. Only then will the people back a government that can pursue the tough programme needed to turn the country around. To get to that point, bailout cash for both the government and the banks probably has to be turned off.

It might be thought that the country is already on the edge of the abyss. This month’s election savaged the two traditional ruling parties which were backing the bailout plan that is keeping the country afloat. Extremists of both right and left gained strength – voters liked their opposition to the plan. But nobody could form a government. Hence, there will be a second election on June 17.

Will this second election express the Greeks’ desire clearly: stick with the programme and stay in the euro; or tear up the plan and bring back the drachma? That is how Greece’s financial backers in the rest of the euro zone, such as Germany, are trying to frame the debate. But the electorate doesn’t yet see the choice as that stark. Roughly three quarters want to stay with the euro but two thirds don’t want the reform-plus-austerity programme.

The next election is unlikely to resolve this inconsistency – or at least that is the conclusion I came to from a trip to Athens last week. The battle for first place is between Alexis Tsipras, the young leader of the radical left SYRIZA party, and the centre-right New Democracy party led by Antonis Samaras.

A victory for Samaras might seem to offer the hope that Greece will stick with the programme and the euro. He has, after all, campaigned for both. However, even if he comes first – which he did in this month’s election – he will not have a parliamentary majority. He will either have to stitch together a majority coalition or govern a minority government. Neither is the recipe for a strong government.

A Samaras government could theoretically deliver a positive shock by moving full-steam ahead on reforms and gaining so much credibility with Greece’s euro zone partners that they give Athens real help in turning around the country. But it is far more likely that he will be timid and the rest of the euro zone will throw Greece only a few crumbs. The economy, which has gone from bad to worse in the last couple of months of electioneering paralysis, would continue its nosedive, Samaras’ popularity would evaporate and after a few months his government would collapse.

A victory by Tsipras in next month’s election might seem even worse. After all, he will probably set Athens on a collision course with the rest of the euro zone. Last week Tsipras likened the relationship between Greece and the euro zone to that between Russia and America in the Cold War, when both had nuclear weapons that could destroy the other but refrained from firing them. Tsipras thinks the rest of the euro zone is scared that Greece’s return to the drachma would cause the entire single currency to unravel and that the bail out of Athens will continue, even without substantial economic reform.

The impact on the euro zone of Greece’s expulsion would undoubtedly be severe. But the other countries are finally preparing contingency plans to mitigate the damage. Germany, for one, will not be blackmailed by threats of mutually assured destruction.

It is conceivable that Tsipras will blink first, if he wins the election and finds he can’t shift the Germans. But this is unlikely. The typical weasel words of a politician won’t be enough to get him out of a tight spot; he would have to perform a complete somersault. It is doubtful the Marxists in his party would let him get away with this and, if they did, he would certainly lose all credibility in the country.

That said, a victory for Tsipras may paradoxically be Greece’s best chance of staying in the euro because it would bring things to a head rapidly. The country is being kept alive by a dual life-support system: the euro zone and IMF are channelling cash to the government, while the European Central Bank is authorising cash transfers to the banks. If the first tap is turned off, the government will not be able to pay salaries and pensions from July. If the second tap is turned off, the banks could run out of cash within days.

Cutting off Greece’s life support could be the trigger for reintroducing the drachma as the people found the cash machines ran dry. But it could also finally force the people to decide whether they were prepared to back reform – provided the euro zone simultaneously rolled out a proper plan to help the country. A key element of that would have to be to take over the Greek banks and guarantee their deposits, putting the country into a form of financial protectorate.

In such a scenario, a Tsipras government would probably collapse. After all, even if he comes first in the next election, he will not have a majority and so would be relying on coalition partners or governing in a minority. Greece would then need a third election, after which it might be able to put together a national unity government – perhaps even led by Lucas Papademos, the technocrat who ran the country for the last six months.

It is a slim chance full of risks, but probably Greece’s best chance of avoiding the drachma.