A dramatic sell-off in European financial markets on Thursday renewed fears that Europe's banks are too weak to withstand the Continent's debt crisis, increasing the chances that the region's leaders will be forced to pursue radical steps toward fiscal union in order to preserve their single currency.
For more than a year and a half, the euro zone's strategy has been to buy time for its weak nations to regain the confidence of financial markets, while taking tentative steps toward closer cooperation on the bloated budgets that got them in trouble.
That strategy was on full display on Tuesday in Paris, where the leaders of Germany and France presented the latest in a series of initiatives aimed at bolstering the euro zone's architecture. Investors immediately criticized the plan, which included steps toward tax harmonization and stricter budget controls, as inadequate.
The Franco-German proposals, critics complained, laid bare the political inertia within the euro zone that has allowed the crisis to fester for months.
If the region's banks remain under pressure, however, the countries at the euro zone's core, in particular Germany and France, will be left with no choice but to embrace the deeper fiscal union that they have rejected for more than a year. If they don't, the common currency could collapse, thrusting the Continent into political and economic chaos.
"There remains an ongoing tension between a quick fix regarding the debt crisis on the one hand and on the other the policymakers that are working on a step-by-step process," said Nick Matthews, economist at Royal Bank of Scotland. "You are going to have market dynamics forcing the action."
That realization has in recent days prompted Germany, the region's economic powerhouse and an opponent of fiscal union, to reconsider proposals that would force it to accept responsibility for the debts of its neighbors. Thursday's markets rout, the worst in Europe in more than two years, suggests Berlin and Paris may have to act quickly. If investors lose confidence in the region's banks, Europe's financial system could seize up, tipping the euro zone into another recession. The soundings on Thursday were bad across the board.
Morgan Stanley cut its euro-zone growth forecasts for this year and next. Plans for the second Greek bailout, once thought firm, were jostled by demands from Finland, Austria and others that Athens post collateral for its rescue borrowings.
The benchmark indexes in Paris and Frankfurt both fell more than 5%. The Milan bourse fell 6.1%. Some of the worst carnage hit Europe's banks.
That is particularly dangerous. Weakening banks could choose to hoard cash, crimping liquidity. In the extreme, banks could require money for recapitalization from their governments. (The cost of massive bank recapitalization doomed Ireland last year.)
With the euro zone's weaker countries scrambling to find low-cost financing, the currency union can't afford either of those things.
Economists and analysts say the bloc is running out of small steps. The shockingly sudden rise in the yields of Italian government bonds earlier this month made clear how quickly an indebted country could unravel if markets freeze it out of financing. For now, the European Central Bank is propping up bond markets in peripheral countries by stepping in to buy government bonds. But the ECB has made clear it won't do this indefinitely.
Among potential steps debated in Europe is a system of centralized borrowings by all 17 members of the euro zone, with debt issued by an EU agency and every member vouching to stand behind the bonds used by its peers. Such euro bonds would dispel concerns Italy or Spain might not be able to get the financing they need, as it would be provided centrally. As a unit, the euro zone has relatively attractive fiscal prospects: Government deficit of 4.3% of gross domestic product is expected this year and debt of 88% of GDP.
But euro bonds would come with a huge political cost. French President Nicolas Sarkozy Tuesday rejected them, saying they'd lead to strong countries being "in the position of guaranteeing debt they do not control."
That, Mr. Sarkozy said, would be politically difficult to justify in strong countries, but also ineffective at curbing the fiscally imprudent. As they could borrow freely at low cost, there would be little incentive to stop. Thus, Mr. Sarkozy said, a euro-bond system would need to come with strictures: each government saying to its peers what it can and can't borrow, and thus what it can and can't spend.
But, Mr. Sarkozy said, European institutions "don't have the democratic legitimacy" to forbid individual states from spending.
Without a euro bond, European policymakers must craft a solution that achieves three aims: Removing the need for the ECB to buy bonds continually on secondary markets; ensuring that troubled countries have access to financing; preventing the strong countries from being dragged down by the weak. A number of solutions are under consideration but all of them carry risks. In Europe's wealthier northern tier, discontent over paying for the profligate south could give rise to populist far-right parties that reject putting Europe's needs above national interests. And Europeans in the south would likely bristle at being forced to relinquish national sovereignty over government spending as a condition to receiving support.