Incredible Europeans: Right now, the ECB has too much credibility on the inflation front; the spread between German nominal and real interest rates, which is an implicit forecast of the inflation rate, is pointing to disastrously low medium-term inflation:
I.e., inflation of 1.24%/year in the eurozone.
On the other hand, there has been a severe loss of credibility in the promises of European governments other than Germany to repay their debts. There are strong self-fulfilling aspects to this crisis of confidence — which is why Europe desperately needs the ECB to act as lender of last resort, and short-circuit the vicious circles.
The spread between German and Spanish 10-year bonds is now 4.41%/year--which if you expect a 40% depreciation from Spain in the event of a Euro breakup, gives you a 110% risk-neutral measure of a Euro breakup. (Yes, I know: risk-neutral measures aren't probabilities: they are probabilities of different states of the world multiplied by marginal utilities of wealth in those states normalized to add up to 100%. They are still useful things to calculate.)
[T]he ECB will defend its credibility. And it will end up as the highly credible defender of the value of a currency that no longer exists.
At this stage, it really does seem to me that the best thing the United States could do for Europe--and also for itself--would be for Tim Geithner to announce that a weak dollar is in America's interest.
The hope is that would change the European Oligarchs from focusing on how credibility requires monetary and financial austerity to focusing on how competitiveness requires monetary and financial expansion. I would give it a 50%-50% chance of working.