The euro-zone countries now have to understand that, in reality, Germany's bargaining position is very weak. In the event of a break-up of the euro, Germany would suffer considerably:

- not only because of the appreciation of its currency and the resulting loss of competitiveness, as in 1992-1993 (Charts 5A and B);

- but above all because of the capital loss that would follow the depreciation of the exchange rate of the other euro-zone countries against Germany. For Germany, with its external surpluses (Charts 5A and B, 6A) has accumulated substantial external assets (Chart 6B) whose value in Germany's currency would plummet in the event of a break-up of the euro.

It is impossible to imagine that Germany would seriously consider a loss of competitiveness of 30 or 40% and a wealth loss of EUR 1,800 to 2,400 billion.

Therefore, we believe that Germany will accept to participate in coordinated growth stimulus measures for the euro zone to pull it out of the depressive trap seen above. This can involve:

- a coordination of fiscal policies, with a fiscal stimulus in Germany - which has the means to implement such measures (Chart 1 above) - and an easing of the required pace of reduction in the fiscal deficits (Table 1 above);

- an increase in European structural funds, and in investments by the EIB (Tables 2A and B above).

Eoin Treacy's view Spanish spreads hit a near-term peak close to 540 basis points over Bunds late last week and have contracted somewhat since. So far the reaction has been relatively similar sized to that posted in May and a sustained move below 475 basis points will be needed to confirm improving confidence. In absolute terms, Spanish yields tested the upper side of the yearlong range last week and have at least paused.

Something David has mentioned during previous crises comes to mind (Also see Comment of the Day on August 5th):

"However a crucial point to remember about a crisis - any crisis, is that once known, markets adjust so quickly that the situation has to be seen to be deteriorating for those trends to continue. If the worst case outcome does not look likely, they usually bounce back very quickly."

This focus of this crisis has never been about the money. In aggregate, the Eurozone has the financial resources to manage peripheral debt issues. The question remains whether the political will exists to push through the reforms necessary to create a federal Europe with a transfer mechanism, federal deposit insurance and broad taxation powers. The primary reason the region has lurched from one drama to the next is because of a lack of political will to make the necessary decisions to ensure the Euro's survival indefinitely. The problem for voters is that these steps are unpalatable and threaten national sovereignty.

As mentioned last week, the higher Spanish spreads rise the greater the likelihood assistance will be forthcoming. Mario Draghi today announced the ECB is “standing ready to act”. He also stated that the ECB cannot solve the crisis on its own and called on governments to do more to alleviate risks. The most likely scenario remains that the EU will eventually evolve into a ‘united states of Europe' but the path to that outcome is likely to remain bumpy. We appear to be drawing increasingly close to the next lurch toward fiscal cohesion and increased liquidity provision.

The Euro Stoxx Index has returned to test the September and February lows in the region of 200. The Index has rallied well over the last few days but a sustained move above 220 will be required to break the three month progression of lower rally highs and indicate more than a temporary bounce.