U.S. President Barrack Obama, new French President Francois Hollande and Italy's technocrat Prime Minister Mario Monti arranged a conference call with Merkel to persuade her to lift her veto on using Europe's available bailout funds to help rescue its banks.
The version reported in the Italian press stated the leaders tried three times in the course of the call. The first time was friendly and she answered "No," in English. The second time they were still polite but pressed her and she replied "Nein," in German. The third time they spoke with more urgency and a certain amount of tension and once again it was "Nein."
The problem is that both sides had very good arguments. Obama, Hollande and Monti were right to warn that the ominous threat of a run on European banks was building fast, with the prospect them looming of the collapse of a major bank, a European version of the Lehman brothers bankruptcy of 2008.
What might be called "a bank trot" (since it isn't yet a run) seems to be under way in Spain, where more than $100 billion has been transferred to German, British and Danish banks in recent weeks and the Danish central bank (not in the euro system) has been cutting interest rates to deter more flows.
The run of capital flight is infecting Italy and even France, as fears of a Spanish banking crisis is spreading the contagion to banks on Rome and Paris.
Moreover, central banks in emergent markets, led by China and Brazil, have been "dumping euros" London's Financial Times reported Monday, citing currency traders at Citibank and Bank of America. The euro fell 7 percent against the dollar in May.
It was in this context that the three leaders pressed Merkel to use the $300 billion immediately available from the European Financial Stability Facility to support the troubled banks.
"Germany does not want the fund to spend billions in exchange for collateral from ruined banks," she replied, the version leaked by Italian officials said. "I don't see why we should end up holding bits of bankrupt lenders."
Merkel instead is pushing the Spanish government to follow Greece, Ireland and Portugal in accepting official bail-out funds under the stringent conditions that have proved so controversial in those countries.
The problem is that once that happens, the European fund would instantly get the top priority for repayment and private lenders would be "subordinate" or pushed down the waiting list. What this meant in Greece was that the private lenders had to take a big loss on their loans. After that Greek experience the markets, already demanding more than 6 percent interest on Spanish loans, would be unlikely to lend to Spain at all.
The irony isn't just cruel, it is vicious. Obama, Hollande and Monti were right to say that a European bank run would trigger a global meltdown. But Merkel is right to say that neither she nor the German taxpayer are prepared to use funds intended to bail out euro countries to save badly run banks.
What she means is that she isn't prepared to lose next year's German election to save Greeks, Spaniards (and Italians, if need be) from the results of their own spendthrift folly.
Not for the first time, Merkel is misreading the situation. In Spain and much of southern Europe the banks and governments are supporting each other like a couple of drunks, or perhaps like Mark Twain's two impoverished families, "who made a modest living by taking in each other's washing." The banks borrow money from the European Central Bank buy their government's bonds. The governments then guarantee the banks and even help them recapitalize, even if they have to sell more bonds to do so.
The financial world is in for an interesting few weeks. On Thursday, Spain is having a debt auction and on June 17 the Greeks have a new election. Then the Europeans have another summit, with talk of a new long-term plan for a European banking authority.
And meantime Italy's former Prime Minister Silvio Berlusconi, on whose support the Monti government depends, has been exercising his talent for saying the unthinkable. He declared last week: "If Europe refuses to listen to our demands, we should say 'bye, bye' and leave the euro. Or tell the Germans to leave the euro if they are not happy."
He even sketched out a strategy which would certainly drive the Germans from the nest, suggesting that Italy use its own government facilities to print euros, which is supposed to be done only by the European Central Bank.
This is a nuclear option. If Italians or Greeks start printing their euro notes it would be like official counterfeiting. Germany's only recourse, short of war, would be to scuttle back to the deutsche mark, a move more and more Germans might welcome.
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