Breaking up the eurozone

At the end of the day on Wednesday, the markets got confirmation that there is no such thing as being too cynical about the willingness of European politicians to act. Sources that included Reuters and Germany's Handelsblatt reported that Germany and France were in talks to break up the eurozone.

"France and Germany have had intense consultations on this issue over the last months, at all levels," a senior European Union official in Brussels told Reuters. "We need to move very cautiously, but the truth is that we need to establish exactly the list of those who don't want to be part of the club and those who simply cannot be part," the official said.

Does that seem nuts to you? After all, that's not the kind of thing that reassures the markets during a crisis. And it's not a solution to the current problem, since any change in who belongs to the eurozone would require treaty amendments that would take months to negotiate.

But I don't think the report is crazy. In a speech to students in Strasbourg on Tuesday, French President Nicolas Sarkozy said that a two-speed Europe was the only model for the future.

And German Chancellor Angela Merkel has called for changes to the European Union treaty that would include tighter integration among eurozone members and a change in who belonged. European Union officials have told Reuters that changing the European Union treaty will be on the formal agenda at a Dec. 9 summit in Brussels.

That probably doesn't strike the markets as a solution to the current crisis.

So where does that leave us?

It leaves us watching eurozone leaders outside Italy attempt -- again -- to build a firewall that will prevent the crisis from spreading further. This time, the firewall is designed to stop the crisis before it engulfs France, and the mechanism is a rule that requires selected big European banks to raise more capital. The idea, I guess, is that the markets will decide that the European banking system is safe and solid if banks meet these rules. (Why this requirement would convince anyone is beyond me, since it so clearly bends accounting rules to favor some banks. Especially French banks.)

Unfortunately, even with this extra capital, if Italy goes down, French banks go down. French banks hold 100 billion euros of Italian government debt and 300 billion euros of Italian private debt. That's more than enough exposure to rattle the big French banks.

The perverse effect of this attempt at building a firewall to prevent Italy from torching other countries in Europe may be a global credit crisis that hits developing economies especially hard.

European banks have made it clear that they will meet the new 9% capital ratio rules by shrinking their balance sheets. That means selling off existing assets and making fewer new loans. That's a big deal, because continental European banks are the source of about 21% -- or $530 billion -- of the outstanding international bank loans in Asia (excluding Japan) as of the end of the second quarter of 2011, according to the Bank for International Settlements. If loans become harder to get or simply more expensive, that will be a drag on growth for these economies in a world where economic growth in general is slowing.

Is there a rescuer to be found?

Could the market be wrong in its Wednesday panic? Certainly.

Italian politics could be less than completely dysfunctional, and a caretaker government with a degree of credibility with the financial markets could emerge from the morass in Rome. And that government could push enough reforms to restore some faith in Italy's finances. Remember that although Italy faces huge long-term challenges in generating sufficient economic growth and in increasing productivity, the country is by no means broke in the near term unless it wants to be.

But I don't think any action in Rome alone will be enough to turn the tide.

Somebody on the eurozone stage will have to step up and prove the markets wrong. I don't see this coming from France's Sarkozy, who is too busy managing his own domestic political battles and austerity budget. I certainly don't see this from Germany's Merkel, who has been hamstrung by the German constitutional court and the Bundestag.

The only possibility is the European Central Bank's new president, Mario Draghi, who could --after Italy has proved that it's worth rescuing by passing a new austerity package -- move to buy enough Italian bonds to get yields back below 7%. The bank has the power. Does it have the political will?

And if not Draghi, who else? I don't see another candidate.

I think we'll know within the next two weeks. If Italy passes the austerity package and the European Central Bank intervenes enough to start bringing yields on Italian government debt down, we'll have our answer.

If not, the crisis will get worse.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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