Germany, the ECB and the markets: Time to choose

Is the crisis in the eurozone the international equivalent of a bank run - an irrational market panic? Or is there something more fundamental going on - a moment of truth for countries that have borrowed too much, for too long?

Angela Merkel has some tough decisions to make

This is the basic question now hanging over European policymakers, as they try to forge a common response to the market mayhem of the past few weeks. The problem, as I discussed on the Today programme this morning, is that Germany's answer is different from most of the others.

Like most politicians on the Continent, Angela Merkel thinks markets are irrational creatures. But in this case, the German Chancellor thinks investor pressure on countries like Spain and Italy - even France - is at least partly justified.

That is why she keeps saying that countries are masters of their own fate. They just need to try harder.

Put it another way: it might be contagion that we're seeing, but if the disease is spreading, that only makes it more important, in Germany's view, for governments to take their medicine.

Increasingly, other policymakers - inside and outside of the eurozone - take a different view. They look at rising government borrowing costs - bond yields - for the likes of France and, especially, the Netherlands and Austria (whose economies, if anything, are stronger than Germany's ) and they see a market panic, which has less and less to do with the economic fundamentals.

Of course, even a panic can be rational. If you think the very existence of the eurozone is now in question, then the funding pressure we are seeing across Europe - not just governments but also, as the Wall Street Journal and the FT report today, banks and major companies - is entirely rational. It is also prudent.

But the German Chancellor is not supposed to think the existence of the euro is in question. In fact, it is at the heart of her approach to the crisis - politically and economically - that the single currency must not only come out of this in one piece, but come out of it stronger, with the all members committed to behaving more like Germany.

Even that Germanic future for the euro might not be possible, if the market mayhem of the past few weeks is allowed to turn into a full-blown credit crunch, as many now fear. That would make it all but impossible for countries like Spain and Italy to re-balance their economies - or grow out from under the massive debts (public and private).

And, we should not forget, a prolonged financial crisis could also have devastating consequences for Germany.

Commentators naturally focus on the widening spread between German government borrowing rates (bund yields) and that of other countries. But it's striking that Germany's own bond yield has actually crept up slightly in the past few weeks. That is the not what you would expect if it were truly a "safe haven".

Investors know that even Germany, with 80% of GDP public debt and a massive dependence on exports to the rest of Europe, will not be a safe port in the storm if the crisis gets much worse.

Which brings us back to the question I started with: is this more like a bank run - or a moment of truth for the eurozone, and the great public and private imbalances between its members that have been allowed to build up for so long?

The answer, of course, is that it is both. David Cameron knows that. Angela Merkel knows that. But the German Chancellor needs to decide quite quickly whether she is willing to let the bank run element take over - let the financial markets run away with the idea that the euro is about to fall apart.

If she doesn't want that to happen, she needs to say so right now. And she needs to tell her officials to look for a way to deploy the balance sheet of the European Central Bank (ECB), in support of the euro, without putting its credibility or independence at any greater risk than they already are.

Perhaps, as I discussed in the summer, the rescue fund - the European Financial Stability Facility - could be given a bank licence, so it could borrow from the ECB, but governments themselves would be taking most if the credit risk from lending on to troubled governments.

Or maybe there is another, equally imperfect solution out there. The ECB president Mario Draghi is right to point out today that governments have been remarkably slow to deploy the tools for responding to the crisis that are already available to them.

But we may be long past the time when even the second, or third, best solution to the crisis was possible.

Today, in her meeting with Mr Cameron, might not be the day to do it. But some day soon, Mrs Merkel will have to decide whether she is going to allow a market panic about the future of the euro become self-fulfilling.