In a development that I definitely didn't expect, Germany had a disastrous debt auction today, driving its borrowing costs up over 2% for its 10-year notes. I think this reflects, above all else, an extreme vote of no confidence in the European Central Bank by the market. My mode of thinking about the European crisis had been of the ECB as an extremely deficit hawkish appendage of the Bundesbank. That is, it set monetary policy based exclusively on developments in Europe's biggest economy, Germany. I saw the crisis driven, in large part, by the ECB's stubborn refusal to accept marginally higher inflation in Germany in order to ease the burdens of deflation in the peripheral countries. In the case of an asymmetrical shock, like the one that struck when Greece went bust and Spain and Ireland's property bubbles burst, those countries needed wages and prices to fall relative to the rest of Europe's in order to restore export competitiveness and allow them to essentially export their way out of trouble. But, absent higher inflation in the core countries like Germany, this would mean lower nominal wages and prices in the periphery, which in turn would make those countries' real debt burdens higher (not to mention bring on a massive deflationary recession that would cause huge suffering).
In this model, I expected spreads between German and peripheral sovereign debt to widen until those countries were forced out of the Euro. The widening spreads make sense because, in the case of a Euro collapse, the new drachma and new peso would be revalued at substantially less than the deutschemark. However, that development in turn means that Germany's borrowing costs shouldn't rise, since investors would see their bonds appreciate rather than depreciate if they were revalued in deutschemarks, provided Germany doesn't default.
I think what the failed auction reflects, though, is one of two things. The first is the possibility that Germany might opt to take on the liabilities of the peripheral countries, which would put substantial fiscal pressure on the Germans. However, I think that's unlikely-- with a cooperative central bank, a one-time addition of debt could be alleviated with steady growth, provided it wasn't choked off by the central bank. Which is, I think where the heart of the problem lies. The ECB is hawkish to the extreme on inflation; if it sees a possibility of inflation, it raises rates. Which is a huge problem when economic growth Euro-wide is stagnant and there's mass unemployment. I think the fear is even contraction in Germany wouldn't lead the ECB to raise rates, out of its misguided inflationary fears. Then, in a collapse, their further misguided fear of inflation would keep them from acting. This still doesn't explain the German borrowing problem-- even in a Euro collapse, their debts would get paid off-- but I think it may just be markets' fear of anything having to do with the Euro that's driving them away from German bunds.
To use a metaphor I really like, the ECB is the fireman who shows up to Noah's flood with his fire extinguisher and gets swept away. To use Paul Krugman's (probably superior) characterization, the ECB is determined to cast itself as the highly credible defender of the value of a currency that no longer exists.
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