If it wasn’t so painful to watch and live through, the European movements towards a hopefully final rescue of the euro could be a modern opera[1]. Last weekend in Washington (annual IMF meetings), we could hear from senior EU and ECB officials about an idea to leverage the EFSF to bring ‘shock and awe’ with a plan that could reach more than 2 trillion euros. The fact that European officials were thinking in those terms, showing they finally understood the magnitude of the problem at hand, was totally refreshing and led to the global rally earlier this week. The questions still are: can 17 governments plus EU bodies agree on this and implement quick and efficient enough? Are the Germans on board?

The crisis morphed over the last few months from one of the periphery to one that threatens the euro itself, especially when Italy joined the group of countries losing its capacity to fund at ‘reasonable’ (or sustainable) levels. The last few weeks were particularly virulent. Most likely, only ‘shock and awe’ can turn this around, à la a show of force in the shape of a very large rescue effort. In other words, it is no longer about the proper structural reforms that create a fiscal agreement theoretically consistent with a monetary union. Now it is about rescuing banks and sovereigns, about the size of the package, about the leadership that shows an understanding of the crisis and what is at stake. This crisis is now a banking crisis, a sovereign crisis, and a political crisis. The solution has to address those three dimensions. And the ideas floated last weekend were the first indications that the ingredients are finally coming together.

Markets started to recover, because there seems to be an effort to put these ingredients together, which reduces the probability of the extremely negative scenario (an EU implosion). However, markets have seen nothing in terms of concrete announcements. As a matter of fact, other senior officials (especially in Germany) made some comments not totally consistent with the ideas shared in Washington last weekend.

Here is what we think markets expect, and an assessment of what is likely. Greece should be pushed to produce a steeper though orderly debt restructuring (steeper than the currently discussed 21% NPV cut as part of PSI, see ‘Germany’s Uruguayan steps on Greece‘, June 9, 2011). If the EFSF cannot be quickly expanded, then it should be leveraged at least 4 times. Capital injections to banks in Europe are most likely a necessary condition for success, though not sufficient (most likely, the richest nations will have to pitch into their own banks unilaterally). Recall that in 2008/2009 in the US the government backstopped all money market accounts and increased deposit insurance. Thus, the ECB needs to get the political backing to become significantly more active. A simplistic comparison of the US and Europe (GDP and the size of banks) leads us to believe that the knee-jerk threshold for success is a total envelop of 3 trillion dollars.

Europe has taken a few steps in the right direction. The agreement on July 21^st broke the debt restructuring taboo, and indicated that further integration is the medium-term objective (see ‘Euro fiscal union or euro break up‘, July 20, 2011). The ideas mentioned last weekend by EU and ECB officials point in the direction of leveraging EFSF and bank recapitalization. Germany just approved the July 21^st deal, and its Finance Minister subsequently said that the EFSF has to be used efficiently, and that the next few steps require original thinking and are yet unknown (opening the door to a more ‘structured’ use of the EFSF).

The direction seems clear. The risk is on coordination failure and the pace of getting many governments and institutions behind a bold and drastic plan. The next few weeks are critical.

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[1] The title of this article is just to create some punch, as the theme of ‘Cavalleria Rusticana’ bears no relationship with the ideas here, I think…