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Europe on the Brink

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Europe is now on the very edge of an economic abyss. And Germany is finding that it cannot survive as a smug island of fiscally conservative prosperity while the rest of Europe goes down the tubes. It is anybody's guess whether Europe's leaders will shift course in time. If they fail, it won't be pretty. The fact that Germany's fate is now more closely linked to that of its neighbors actually offers a ray of hope.

Until last week, Germany had been the safe haven. As speculators pulled money out of other countries, in a bondholders' equivalent of a run on the bank, German government debt was oversubscribed, causing interest rates on German bunds (government bonds) to fall below 2 percent. The spread between German rates and the rates that "weaker" countries had to pay to sell their bonds was treated as a precise barometer of market confidence in a given nation's debt.

For the Germans, this was a huge windfall. My friend Sony Kapoor, who directs the progressive think tank Re-Define in Brussels, calculated that Germany's cheaper borrowing costs due to the panicky bond-market flight from nations like Greece, Italy, Spain, Portugal and Ireland saved the Germans some $26.7 billion in interests costs between 2009 and 2011, and another $20 billion in low-interest bonds already locked in for the future. (It is no accident that the word Schadenfreude -- translated as joy at another's misfortune -- is a uniquely German coinage.)

But then on Thursday, as Americans were taking a day off for Thanksgiving, the unthinkable happened. Germany had trouble selling its bonds. The bond market, in its panic, was fleeing even the safest haven. Europe is now approaching a Lehman Brothers moment, where nobody trusts anybody else's promise to repay a debt.

Not to be joyful at another's misfortune -- the crisis will keep cycling back to haunt the United States -- but the fact that contagion has now reached German shores is more than poetic justice. The European Central Bank, with its concern for fiscal discipline and price stability über alles, operates with a deeply Teutonic soul. It is the tribal successor to the German Bundesbank, the most risk-averse and inflation-phobic of all central banks. This view, however, is no virtue when the greater peril is general panic and deep deflation.

In 1873, the British financial journalist Walter Bagehot pointed out that the Bank of England kept the banking system functioning by serving as a lender of last resort in times of crisis. This is what the European Central Bank refuses to do.

Or, to be more precise, the ECB, despite its qualms, is now shoveling money at commercial banks but will not support national bond markets. That tells you something about who really runs the show -- bankers. This double standard also reflects German policy preferences. Better to teach a lesson to nations in fiscal distress, even if the consequence is to drag down the entire European economy. But now that turkey of a policy has come home to roost.

Whatever its other failings, and they are legion, our own Federal Reserve under Ben Bernanke has not been shy about buying the securities of both shaky banks and the U.S. Treasury. Had the Fed failed to do so, our economy would be even further under water. Bernanke's failing has been in the regulatory side. He is still far too trusting of markets.

The European Summit of Oct. 26, with its offer of partial debt relief for Greece and a new pot of borrowed funds for beleaguered European banks, might as well have happened in the 19th century. The crisis has now moved to a whole other phase, where the remedies that looked adequate even a month ago (and were not) are not impressing panicky money markets.

Many mainstream critics argue that the European Central Bank should stop dithering and support sovereign bond markets. Others go further and call for a common European fiscal policy and common European sovereign bonds. Still others contend that the Euro was doomed from the start; putting Greece and Italy in the same currency with Germany and the Netherlands was never a good idea, because this denies countries with weak economies of temporary crises the option of devaluing.

All of these criticisms have some merit, yet all miss the deeper point. Once we get through the management of the immediate panic -- which is not yet assured -- we need to treat the deeper disease. This crisis occurred because bankers and shadow bankers (such as the hedge funds that are betting against Europe's bonds) have too much power.

Bankers had too much power when they invented the highly leveraged toxic securities that caused the collapse, and now they have too much power over the fate of entire nations as political leaders seek to clean up the mess that the bankers made. The ability of governments to finance their debts should not be dependent on the caprices of private speculators.

Does that sound crazy? It was national policy in the U.S. in the 1940s, when the Federal Reserve pegged the rate on government bonds, and it was international policy in the 1950s and 1960s during the Bretton Woods era -- a period of high growth and broadening prosperity.

There is no shortage of technical ways out of this crisis. But the political precondition to all of them is to dethrone the rule of the bankers.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.