LONDON (Reuters)- Here's a nightmare for Europe's leaders to ponder as they prepare for yet another summit to tackle the euro zone crisis: a bond auction fails in Spain, spreading solvency worries to Italy and beyond and triggering uncontrollable bank runs that spell the single currency's end.
Is such a scenario likely? Policymakers hope not. Is it possible? They fear it might be.
What is beyond dispute is that more and more economists and academics are asking whether the euro's problems are so deep-rooted that the currency is beyond salvation.
David Marsh, co-head of OMFIF, a forum for central banks and sovereign wealth funds, likened the 13-year-old euro to a child increasingly neglected by its parents.
"I don't really see what's going to hold the euro up. But it's difficult to tell the timing," he said.
If time is called on the euro one day, austerity fatigue could be the catalyst. Perhaps the new coalition government in Greece, now in its fifth year of recession, will throw up its hands and say ‘no more'.
Voters in countries that are more critical to the single currency's future could also tire of the belt-tightening demanded of them by the European Commission and the markets.
Former Italian prime minister Silvio Berlusconi, who still heads the country's main conservative party, has turned more skeptical since being ousted from power last November, saying on his Facebook page last week that "leaving the euro is not a blasphemy".
A new anti-euro protest group in Italy, the Five Star Movement led by ex-comedian Beppe Grillo, is enjoying support of around 20 percent, according to opinion polls, putting reformist Prime Minister Mario Monti on the defensive.
Equally, creditor fatigue could tip the euro over the edge.
What if the Netherlands elects an anti-euro government in September? Or if Chancellor Angela Merkel feels ahead of her re-election campaign next year that she cannot ask German voters to keep digging into their pockets to underwrite Europe's under-performing southern periphery?
Such doubts are already bubbling to the surface.
"There's now a growing suspicion that Germany is simply not ready to accept the level of debt mutualisation necessary to restore confidence and keep the single currency project alive - or, if it is, that it will do so only at a snail's pace and on terms which are politically and economically unacceptable to Spain and Italy," said Nicholas Spiro of Spiro Sovereign Strategy in London.
Or perhaps there will be a catastrophic, unforeseen financial or political accident. Recent history shows that cannot be ruled out.
And that is just in the short term. Leave aside for now the conundrum of how euro zone laggards will restore economic competitiveness so they can withstand the discipline imposed by a fixed exchange rate, or how proud nation states such as France will bring themselves to surrender sovereignty in return for getting to use Germany's AAA credit card.
IT'S THE POLITICS, STUPID
Yet though the obstacles facing the euro are daunting, the main lesson of the debt crisis so far is that markets underestimate at their peril the political commitment of Europe's leaders to do what is necessary to preserve the single currency.
"The euro crisis is in some ways mind-bogglingly simple to solve ... because it isn't economics, it's politics," Jim O'Neill, chairman of Goldman Sachs Asset Management, told Reuters.
"If Angela Merkel and her colleagues stood there together with the rest of the euro area ... and if they behaved as a true union this crisis would be finished this weekend," he added.
A break-up of the single currency would plunge the euro area into a deep recession and throw millions out of work. Germany would not be spared and could face a bill running into the hundreds of billions.
It would also mark the end of six decades of ever-closer integration aimed at cementing peace and prosperity on a continent steeped in the blood of two world wars.
The demise of the euro would not likely usher in fresh conflict. But it could unleash forces that chip away at other pillars of the European Union, such as the single market and passport-free travel, and would deal a body blow to Europe's influence and standing in the world.
Erik Nielsen, chief economist at Italian bank UniCredit, said political leaders were now trying to make up for past procrastination by bringing about urgent fiscal and political changes that usually take several years. But this did not imply an imminent risk of a breakdown of the euro.
"As I have argued ad nauseam, it's a political project, and political leaders are unlikely to throw in the towel because markets don't like the policies," Nielsen said.
CROSSING RED LINES
Indeed, leaders have crossed a number of their own policy red lines during the past 2-1/2 years, improvising time and again to come up with policies that can command a consensus within the euro zone and appease markets, at least for a while.
The no-bailout principle was sacrificed on the altar of rescue programs for Greece, Portugal, Ireland and, just this week, Cyprus. The depth of Greece's woes put paid to the golden rule that private creditors should not be made to take writedowns on their holdings of government bonds.
The independent European Central Bank has also swallowed hard and made difficult compromises to ensure the survival of a currency that is, after all, the very reason for its existence.
Last year, the ECB conducted large-scale purchases in the secondary market of bonds issued by peripheral countries including Italy and Spain, even at the cost of prompting the resignation of two leading German central bankers, who saw the program as breaking the taboo against monetary financing of governments.
In an even more dramatic initiative, the ECB rode indirectly to the rescue of Rome and Madrid a second time by lending euro zone banks more than 1 trillion euros for three years. Banks in Italy and Spain dutifully used the money to secure their own funding needs and to stock up on their governments' bonds.
Yields fell sharply for a while but have once more climbed amid worries that Spain in particular will not be able to get a grip on its deficit, bloated by a burst housing bubble and over-spending by regional governments.
"The creditor countries led by Germany are always willing to do what is necessary to avoid a cataclysm. But that is not enough to resolve the crisis so it continues growing. Tensions in financial markets have risen to new highs," George Soros, the financier, said in a newspaper.
THE PRICE OF FAILURE
A failed bond sale can sometimes galvanize positive changes.
Canada, deep in the red at the time, came close to being unable to sell its debt in 1994. With just 30 minutes to the auction, the central bank had not received a single bid. The close call led to deep spending cuts that eventually turned Canada into a bond market darling.
In Europe the fear is that a similar buyers' strike in Spain or Italy would not be a force for good but would drive the shunned government into a bailout by the EU, the ECB and the International Monetary Fund. The bill would stretch the euro zone's rescue funds to the limit and the risks of contagion to other wobbly countries would be severe.
The value of the sovereign bonds in question would plummet, exposing gaping holes in banks' balance sheets that their governments would not be able to fill.
Indeed, it is because it cannot not raise enough money from the market that Spain has had to ask the euro zone to borrow up to 100 billion euros to recapitalize weak banks.
At that point, depositor flight into safer havens overseas would be rational. Greek banks, after all, have lost 30 percent of their deposits since the start of 2010.
European officials privately acknowledge that banks are a weak link in the current architecture of the single currency. The summit in Brussels on Thursday and Friday will seek to address the problem by setting out a road map to a banking union. But common deposit insurance, billed as one way of boosting confidence in the currency, seems a long way off.
Even without a pan-euro area guarantee for deposits, though, the EU and the ECB have the tools to stop a bank run and temper a bond buyers' strike as long as the political will is there to deploy them.
The ECB could flood the banking system with cash to meet the demand for liquidity and fulfill its mandate to ensure financial stability. Less likely, it could start propping up bond prices again.
On previous occasions, ECB action came in response to significant government moves - it supported Italy's bonds after a belated willingness in Rome to adopt austerity measures, while the injection of more than a trillion euros of liquidity followed a commitment by euro zone leaders to tough new fiscal rules.
For their part, euro zone governments could resort to their bailout funds, the European Financial Stability Facility and its embryonic successor, the European Stability Mechanism, which will have a maximum of 500 billion euros at its disposal.
To reduce the risk of a failed auction, both funds are authorized to buy the debt of a member state, in the primary as well as the secondary market, upon the request of the government concerned, which must agree to appropriate policy reforms.
A full-blown euro area-wide market run could quickly overwhelm the rescue funds, even if supported by the firepower of the IMF. Goldman Sachs estimates the combined borrowing requirement of Italy and Spain (rolling over maturing bonds plus financing the budget deficit) at about 300 billion euros over the next 12 months.
But even at that point the game need not be up for the single currency. Euro zone finance ministers have the authority to grant the bailout vehicles a banking license that would enable them to leverage their capital by borrowing from the ECB.
ALL EYES ON GERMANY
The question, again, comes down to the political will to resort to unorthodox measures in order to buy time - perhaps years - until a stronger institutional framework is in place.
Germany remains firmly opposed to giving the EFSF and the ESM a banking license. "I regard that as monetary financing," Jens Weidmann, the head of the Bundesbank, Germany's central bank, said on Monday.
Weidmann said the ECB was running up against the limit of its mandate because the failure of governments to act was forcing it to step into the breach. Northern creditors point the finger for this "failure" at southern governments for not getting their house in order.
Capitals on the periphery, and many academics, say Germany must share the blame for its refusal to contemplate any form of debt mutualisation, such as commonly issued euro bonds, except as the culmination of a long process of fiscal and financial integration in the euro zone.
For a start, pooled bond issues or a debt redemption fund were unconstitutional, Merkel said on Monday. "I also consider them to be economically wrong and counterproductive," she added.
But, in extremis, would Merkel and Weidmann want to go down in history as having signed the euro's death warrant?
Markets are pricing in yet another disappointing summit this week, the 20th such "make or break" meeting in 2-1/2 years.
But the talks are likely to show that the will to preserve the euro is far from exhausted. Leaders are expected to agree to transfer responsibility for supervising their countries' big cross-border banks to the ECB as the start of a long haul to a banking and fiscal union.
"While such a transfer would — in itself — not mark a fundamental change to the financial outlook, this concrete and verifiable step, coming as it does with an explicit cost to national authorities in terms of loss of sovereignty, could represent a clearer signal to financial markets of governments' political commitment to further integration and resolving the euro crisis," said Huw Pill, an economist at Goldman Sachs.
(Additional reporting by Chrystia Freeland and Paul Carrel, editing by Mike Peacock and Michael Stott)