(Associated Press file)
Expectations are rising that Friday's summit of leaders of the 27 countries in the European Union will yield a breakthrough. An agreement on tighter integration of the 17 EU countries that use the euro -- especially on budget matters -- would be seen as a crucial first step. That could trigger further emergency aid from the European Central Bank, the International Monetary Fund or some combination, analysts say.
The coming days "will decide if the euro will survive or not," Emma Marcegaglia, the head of Italy's industrial lobby, Confindustria, said Sunday.
French President Nicolas Sarkozy, German Chancellor Angela Merkel, European Central Bank Chief Mario Draghi and even U.S. Treasury Secretary Timothy Geithner will star in a five-day financial drama leading up to the summit.
If the summit is a failure, Sarkozy warned last week, "the world will not wait for Europe."
Sarkozy and Merkel will meet in Paris today to unveil a proposal for closer political and economic ties between the 17 euro countries. While the leaders differ on some of the details, their cooperation has been so tight they have come to be known by a single name -- "Merkozy."
The two agree overall on the need for tougher, enforceable rules that would prevent governments from spending or borrowing too much -- and on certain penalties for persistent violators.
"Where we today have agreements, we need in the future to have legally binding regulations," Merkel said Friday.
Merkel wants to change the basic EU treaty to reflect the tougher rules on euro countries and make them enforceable. Even if there is general agreement Friday, actually putting new rules in place through treaty changes could take more than a year. And many economists fear the new rules alone would not be enough to halt the rise in Europe's borrowing costs.
The hope is that a firm expression of intent, however, would reassure the ECB, so that it can make stronger efforts in the short term. That would give governments time to get their finances under better control and make economic reforms that would improve growth.
The urgency has been heightened in recent weeks as Italy and Spain, the continent's third- and fourth-largest economies, face unsustainable high costs to finance their debts. The yield on 10-year Italian bonds is around 7 percent. Yields above that level forced Ireland, Portugal and Greece to seek bailouts. By comparison, bond yields in Germany, Europe's largest and most stable economy, are roughly 2 percent.
"The eurozone is threatened to face an existential situation if it becomes clear over the next few weeks that several member states cannot cover their refinancing needs, or can only do so at suicidal conditions," former German Finance Minister Peer Steinbrueck told the Sunday edition of German tabloid Bild.
"Everything must be done to hinder the eurozone from breaking up," he said.
Italy, whose government debt is equivalent to 120 percent of the country's annual economic output, needs to refinance $270 billion of its $2.6 trillion of outstanding debt by the end of April.
The size of the problems facing Italy and Spain are considered too large for the existing funds available to the European Financial Stability Facility ($590 billion) and the IMF ($389 billion.) To boost the firepower of the IMF, several economists have proposed that the ECB lend to it.
"We are now entering the critical period," the EU's financial chief, Olli Rehn, said last Wednesday.
That same day, the U.S. Federal Reserve, in coordination with the ECB and four other central banks, sought to give stressed-out European banks some relief. The Fed announced a plan to make it cheaper for banks to borrow American dollars, which is the dominant currency of trade. It was the most extraordinary coordinated effort since October 2008, and it prompted a nearly 500-point rally in the Dow Jones industrial average.
Still, that help did not address the fundamental problem in Europe: unsustainable levels of government debt.
The package also includes measures to spur growth and competition, while aiming to stamp out rampant nepotism. Italian Premier Mario Monti will outline the measures Monday to Parliament, which must approve them.
In a sign of how all 17 eurozone nations see their fates as intricately linked, Dutch Premier Mark Rutte on Monday will be visiting Monti in Rome.
"It is really important that the markets see that Europe is prepared to help the countries in trouble, so long as those countries commit to very tough reforms and austerity programs," Rutte said.
Indeed, the debt loads of countries like Italy and Greece are everyone else's problem.
Germany's economy depends heavily on exports. If economic output in the rest of Europe collapsed, demand for German goods would fall sharply. Across the Atlantic Ocean, the United States depends on Europe for 20 percent of its own exports. And investors in American banks have worried about their holdings of European debt.
The bigger threat to the U.S. and the global financial system is that Europe's debt crisis could spiral out of control.
If governments default on their bonds, banks that own them could take a significant hit. It could become very difficult for these banks to borrow and nervous depositors could flee with their cash. In the worst case, a global financial panic could be triggered, in which banks all over are too skittish to lend to each other. That would cause a credit crunch that deprives businesses of the short-term financing they depend on for day-to-day operations.
With such fears in the air, the United States is ratcheting up its involvement.
Geithner will meet Tuesday in Germany with Draghi and German Finance Minister Wolfgang Schauble. On Wednesday, he travels to France for talks with Sarkozy and the prime minister-elect of Spain, Mariano Rajoy Brey. And Geithner will meet Monti in Milan just before the new Italian leader heads for the EU summit in Brussels.
On Wednesday, many of Europe's most important leaders will be in Marseille, France, for a meeting of the conservative-leaning European People's Party. Merkel, Sarkozy and Spain's new conservative prime minister, Mariano Rajoy, will all be there.
On Thursday, the ECB holds its monthly policy meeting. Many analysts expect one or more actions by the bank aimed at boosting growth and steadying the financial system.
One step would be to cut its key short-term interest rate from the current 1.25 percent. It made a surprise quarter-point cut at November's meeting. Another would be to extend loans to banks for up to two or three years, instead of the current limit of 13 months.
Even more significantly, Draghi hinted last week that the bank could be willing to take a more direct and aggressive role in solving Europe's government-debt crisis, if EU leaders agree to the coordinated belt-tightening being pushed by Merkel, Sarkozy and others.
"Other elements might follow, but the sequencing matters," he said in a speech Thursday.
The ECB extends unlimited short-term loans to banks. It cannot lend directly to governments, including buying their national bonds. It can, however, buy national bonds on the secondary market and has been doing that each week in modest amounts.
Many economists have urged the bank to sharply increase these purchases because that would stabilize or lower the yields on them. That would reduce borrowing costs of the heavily indebted countries that issue them and keep the countries from defaulting.
The ECB has so far resisted expanding its support because it believes that would take the pressure off politicians to cut spending and reform government finances, a concern known as moral hazard. The ECB has also worried that injecting too much money into the European economy could trigger inflation.
EU leaders gather in Brussels for Friday's summit the night before. Sarkozy and others say the stakes couldn't be higher.
"What will remain of Europe if the euro disappears?" Sarkozy asked. He then provided an answer: "Nothing."