01/18/2012 03:48 pm ET Updated Mar 19, 2012

The Euro Elephant in the German Living Room

"The current crisis has uncovered the deficiencies in the construction of EMU (European monetary union) mercilessly," was the uncharacteristically frank admission from Angela Merkel and Nicholas Sarkozy in a joint letter to the European Council President on the eve of the December 9th summit. What is typically exasperating about this telling diagnosis of the euro's ills is that the treatment that the heads of government recommended at the close of the summit -- namely tougher budgetary rules with fines -- neither addresses the deficiencies in the construction of EMU which the leaders referred to, nor offers any prescription for ameliorating the severity of the current crisis.

This yawning gap between rhetoric and reality, between identifying the seriousness of the crisis and delivering an adequate solution, has plagued the euro zone for the last two years as it has wrestled unsuccessfully with the Greek debt crisis. Indeed, the failure of the December 9th summit to produce a "breakthrough of sufficient size and scope to fully address the euro zone's financial problems" was one of the reasons cited by Standard & Poors in its recent decision to downgrade over half of the bloc's 17 countries, including France.

In Germany, the country most capable of providing the political leadership and financial muscle to support the euro and reassure sovereign bond holders, it seems that political elites and the media are far more enthralled with the scandal which has engulfed the country's president over his business dealings. Perhaps a sense of debt crisis ennui has set in but it seems that the Germans are doing all that they can to ignore the undisciplined euro crisis elephant sitting in their Wohnzimmer.

Of course, anyone who has travelled on the Berlin subway will be familiar with how masterful Germans are at ignoring awkward or embarrassing situations, such as the often deranged people who get on and off the trains at regular intervals. However noisy the interlopers get, Berlin's commuters just sit quietly reading their books, seemingly oblivious to the gesticulating demented individual standing in front of them.

For Germany, the euro crisis is the loud crazy person on the Berlin subway. The Germans, who have already provided guarantees and direct support to the European Financial Stability Facility worth billions of euros, keep shelling out money to profligate Peloponnesians and sun-soaked southern Europeans, each time hoping that they won't get back on the train. But it's always been too little money, given too late to do any good. Now, however, the euro train is coming to a dangerous junction and it is the Greeks who yet again are showing every indication of derailing the train before they get kicked off for not buying a ticket.

Although overshadowed by news of S&P's downgrade of France, the far bigger story last Friday was the collapse of talks between Greece and its private creditors to agree a voluntary reduction (or haircut) in the amount of money that Athens must repay. An agreed outcome to these discussions is a precondition for Greece receiving enough money to repay 14.5 billion euros of bond redemptions due in late March, otherwise a Greek default looms large.

The exact effects of such a default are difficult to predict. Some German lawmakers have been wistfully contemplating the prospect of getting the debt monkey off their shoulders if the Greeks were to leave the euro. Greece is an isolated case, they argue, and such an event would not trigger bank runs or a calamitous exit from the single currency of other PIIGS countries such as Portugal, Spain, Ireland and Italy.

The markets are less sanguine, and not just about the damaging effects of a Greek default, but about the survival of the euro itself. Italian five-year credit-default swap contracts, which insure against defaults by governments, point to a worryingly high 30 percent probability of an Italian default. Given that Italy's debt market is one of the largest in the world and too big to save, only the most optimistic German policymaker could pretend that the euro could be saved after a default by Rome.

Unfortunately, these optimistic, yet dogmatic German policymakers are in plentiful supply. As the crisis has shifted from the periphery of the euro zone to the core, rather than raising their game and taking incisive action to boost market confidence in the single currency, German policymakers have been found wanting. Such is their state of denial that one of them, the country's foreign minister Guido Westerwelle, even spoke of the damage being done to market confidence by the ratings agencies' decisions.

In fact, it was the German suggestion in 2010 that holders of Greek debt should not expect to be repaid in full that first created uncertainty in the bond market. This was the first time that a chink appeared in the notion of zero risk European sovereign debt, leaving bond investors asking how risky their other holdings of European government debt might be. The damage was done.

Unlike Herr Westerwelle, Chancellor of the Exchequer George Osborne sees the current problems as stemming from a failure on the part of the euro zone to "provide confidence to the market that they will stand behind their own currency." The S&P downgrades have, thus far, had relatively little effect on the markets, since they largely reflect what investors already know about the inadequacy of the German response to the crisis.

Chancellor Merkel and her policymakers have been acting on the basis that Greece is an isolated case. Yet every reactive decision and feeble measure by Berlin increases the likelihood of a Greek tragedy becoming a Europe-wide one. That will be one elephant and one crazy person that the Germans won't be able to ignore so easily.