Berlin strikes back

Unmoved by the failure of last week's summit, or news this week that Portuguese debt has been downgraded to junk status, Italian bond yields have been pushed into the bail-out zone and doubts have been cast over France's AAA rating, German Chancellor Angela Merkel on Thursday traveled to Strasbourg to tell Nicolas Sarkozy and Mario Monti that she will not allow the ECB to become Europe's lender of last resort.

Merkel instead used the three-way summit with France and Italy to insist that new treaty powers to intervene and punish sinner states remained the key focus of Europe's rescue efforts. She said that she would announce the measures ahead of the next EU summit on December 9. It is worth noting that Merkel made no effort to hide the reality of how decisions are being made in Europe: between her and the French president.

Ms Merkel ruled out a proposal by the European Commission that it issue common bonds uniting the 17 members of the euro, saying that applying the same interest rate to all the euro's members "would prevent us from seeing where the problems lie." One problem behind the euro crisis that Merkel might want to address is the mediocre performance of Germany's banks; but she will find little insight by focusing on risk premiums. The Chancellor is refusing to distinguish between public and private debt, or between countries that have imposed spending cuts, or between countries whose problems are rooted in the property market and those whose problems are to do with their huge national debt. Instead, she clings to the formula that "the markets will eventually correct interest rates" when the euro-zone's members have corrected their deficits.

Needless to say, this assumption is false. We have long moved on from the days when the markets recognized the economic fundamentals of a country, one key aspect of which is the size of its deficit. This new reality is clear given the difference in interest rates that the UK and Spain are paying. But despite Merkel's no-nonsense handling of the rebellion against economic orthodoxy, the French government still has its doubts; and with good reason, given the continued pressure on French borrowing. The markets also sent a message to Merkel on Wednesday after Germany failed to sell almost 40 percent of its bonds. Either investors are tired of making 1.8 percent on German bonds, or they no longer want euros, or perhaps they are already seeing that Germany has no choice but to accept taking its share of Europe's debt.

The other problem that Germany is refusing to see is that Europe will still be in recession throughout 2012, according to the Institute of International Finance, and that means more unemployment and more banking instability. So, while the EU's bureaucracy continues crunching through the processes required to reform treaties and to reach "equal interest rates," the continent's wellbeing will continue to decline by the day.