Europe's leaders have less than a month to strike another grand bargain to rescue the euro zone from a worsening sovereign debt crisis. Contagion in financial markets may have to get still worse to concentrate their minds.
In that short time scale, German Chancellor Angela Merkel must unite her coalition behind potentially unpopular decisions and French President Nicolas Sarkozy must act to defend his country's shaky AAA credit rating.
The new leaders of Italy and Greece must start enacting far-reaching austerity plans and economic reforms despite feuding politicians and social protests. A new Spanish government to be elected on Sunday must convince investors it will take bold action to restore competitiveness and clean up a housing bust.
And the European Central Bank may have to conclude that the biggest threat to stability in the euro zone lies in recession, a credit crunch and the risk of deflation rather than inflation.
If all those conditions are met, then Merkel, Sarkozy and leaders of the European institutions and the IMF may be able to fashion a more convincing plan to tackle the debt crisis and halt contagion than they managed last month.
But it is not even certain that Germany's leaders accept the need for bolder action within weeks.
A series of milestones to watch on the road to a December 9 European Union summit -- the last this year -- will provide pointers to the chances of success.
Merkel seems to have emerged strengthened from this week's congress of her conservative Christian Democrats (CDU) without having her hands tied by Eurosceptics.
By calling for more Europe as the solution to the crisis without spelling out what that entails, she has left herself room for manoeuvre. Attempts by party rebels to constrain her, for example by demanding that deficit sinners be expelled from the euro, were defeated.
Merkel's liberal Free Democratic (FDP) coalition partners, toying with Euroscepticism, remain an uncertainty factor, but political analysts say they have nowhere else to go.
Sarkozy's position is more difficult, six months before an expected re-election bid.
His government adopted a second package of deficit-cutting measures for 2012 last week, but the European Commission said more action is needed in the light of weaker expected growth. France replied that it was already doing enough.
Markets reacted negatively, partly because the adjustment is mostly in tax increases, not spending cuts, but also because of the gloomy growth outlook, French banks' huge exposure to Italian debt, and the election uncertainty.
Merkel and Sarkozy are expected to meet on December 7-8 at a congress in Marseille of the European People's Party, a grouping of mainstream centre-right parties that dominate EU governments.
Before then, the executive European Commission will outline proposals next week (November 23) for stronger euro zone economic governance and publish a consultation paper on the fiercely disputed idea of common euro zone bonds.
European finance ministers meet again on November 29/30 to try to finalise plans to leverage the euro zone rescue fund to provide first-loss insurance on troubled states' government bonds and attract foreign investors to buy euro zone debt.
However those plans face legal complications and market resistance and seem unlikely to provide the desired massive firewall against bond market contagion in the short run.
A clutch of economic indicators due in late November -- business climate, consumer confidence and industrial new orders -- should give a clearer picture of how bad the slowdown is.
That sets the scene for a crucial ECB governing council meeting on December 8 which will consider whether to cut interest rates again from 1.25 percent, and whether to take bolder action to stabilise the euro zone bond market.
The ECB is under massive international and market pressure to intervene more decisively to defend Italy and Spain, but it has so far rebuffed calls to do more, pointing to governments' responsibility for fiscal policy.
EU policymakers say any grand bargain would be likely to involve bolder ECB action in return for stronger implementation of austerity plans and economic reforms by Rome and Madrid.
The policy options on the table are broadly known:
- A second 130 billion euro bailout programme for Greece, including a 50 percent voluntary writeoff by private sector bond holders, depends on Athens' ability to meet its fiscal targets, enact tougher reforms and sell off state assets. The alternative is a hard Greek default that could do wider damage.
- Italy may have to seek IMF assistance unless Mario Monti's incoming team of technocrats can convince investors it is on a sustainable path of fiscal consolidation and growth-promoting reforms of pensions, labour markets and regulation.
- A French proposal to allow the European Financial Stability Facility to act as a bank and borrow money from the ECB remains alive despite rejection by Germany and the ECB last month. If current complex efforts to leverage the EFSF founder in the coming weeks, Paris is sure to raise it again.
- Several other permutations involving the EFSF, the ECB and the International Monetary Fund have been slapped down by Berlin and Frankfurt. They would entail either using euro zone borrowing rights at the IMF to provide capital for a leveraged fund to buy euro zone bonds, or letting the ECB lend to an IMF vehicle for the same purpose. German central banking purists have declared all such options illegal.
- The ECB could change tack and stop sterilising all its purchases of sovereign bonds by taking in an equivalent sum from the market. That would enable it to buy more bonds by in effect printing money -- a European version of so-called quantitative easing (QE) practised by the U.S. Federal Reserve and the Bank of England.
The main objection to QE from guardians of central banking orthodoxy is that it may cause inflation. However, if the euro zone risks possible deflation due to recession and bank balance-sheet contraction, the objection may no longer weigh so heavily.
- The euro zone could take a first step towards eventually issuing jointly guaranteed bonds after it has achieved much more economic integration, with members accepting constraints on national budget sovereignty. Germany has flatly rejected euro bonds so far.
- Some move to stricter enforcement of fiscal discipline in the euro zone is bound to be part of any deal. A Dutch proposal for an EU budget commissioner with the right to intervene in the national fiscal policy of serial offenders may be a key element in reassuring north European creditor countries.
However, some of those who most want stricter controls are most wary of any treaty change that would require a referendum.
(Writing by Paul Taylor; editing by Janet McBride)