Is the euro about to capsize?
In seafaring, there is a concept called the "free-surface effect".
It happens when a surprisingly small amount of fluid can move freely inside a boat.
It is an accident waiting to happen.
As the boat tilts in the waves, the water starts to flood across the floor, pushing up against the boat's lower side.
Instead of righting itself again, the boat begins to list more and more as the water moves inside it, until the boat capsizes.
Something similar is happening to the euro.
When it was created in 1999, there was a fatal flaw. While governments shared a single currency, they continued to have their own separate bond markets.
It was an accident waiting to happen.
Bonds are IOUs that governments issue in their hundreds of billions when they want to borrow money.
The real problem is that what is true of tiny Greece can equally be true of much bigger Spain and Italy”
Just like shares on the stock market, they can be traded by investors.
If investors don't like a government's bonds, they can sell them.
That sends their price down, which by implication means the interest rate the government would have to pay if it wants to borrow more money goes up.Currency master
Investors might sell bonds if they are afraid that a government cannot repay its debts.
Normally this is not a problem. Because normally, a government is the master of its own currency.
It can order its central bank - the currency's guardian - to print as much money as is needed to repay its debts.
This makes the debts of governments like the US, Japan or UK the safest investment in their respective currencies.
Moreover, if a foreign investor doesn't like the British government's debts, not only does it sell government bonds.
It also sells the pound.
That pushes the pound's value down, which helps make the UK economy more competitive, which helps the UK grow, which helps the government raise taxes.
What's more, when one investor sells pounds, another must buy them.
And where will that buyer invest those pounds? Back into UK government bonds.
So by having its own currency, the UK government is pretty much guaranteed its own pool of sterling cash to finance its borrowing.
Now consider the euro.
There is a common misperception that the eurozone crisis is all about debt - it isn't, it is also about growth”
Investors believe that Greece cannot possibly repay its debts.
Unlike the UK, Greece does not have its own central bank that it can rely on to print money and buy its debts. And a 50% write-off of its private sector debts is already agreed in principle.
So many investors have sold Greek bonds. But they could not sell the drachma. There is no drachma to sell.
Instead they could freely move their cash into safer government bonds - German government bonds.
Just like the seawater inside a boat, liquidity - investor's cash - can move freely within the euro from one government's bond market to another's.
And that made the value of Greece's bonds plummet.Greek demonstrations
But despite all the noise, Greece is only a sideshow.
Greece is a small country. And if it stopped repaying its debts and/or left the euro, re-denominating its debts into devalued drachmas, the losses to its bond investors would be manageable.
The danger posed by Greece is rather the power to demonstrate.
It demonstrates how damaging it is to a eurozone economy when its workers' wages rise to uncompetitive levels during the boom years, leaving its economy high and dry, unable to compete and unable to devalue its currency during the bust.
It demonstrates how self-defeating it can be for a eurozone government to try to reduce its borrowing, by raising taxes and cutting spending, when this merely drives its economy into recession, meaning fewer incomes to tax and more unemployment benefits to pay.
And as of this week, it demonstrates that there is a very real possibility that a eurozone member could leave the single currency altogether.
But most important of all, it demonstrates what happens when investors lose confidence in a eurozone government's debts.No return?
The real problem is that what is true of tiny Greece can equally be true of much bigger Spain and Italy.
The best solution would be to have created a single eurozone government bond market in the first place. Too late for that”
And it is in Italy where the real damage is happening.
Investors are afraid Italy might go the same way as Greece. So their cash is beginning to flood out of Italian government bonds, and into German government bonds.
If Greece is the rising flank of the boat, Italy is the midship, and it is listing badly.
It now costs Rome an unprecedented 6.1% to borrow money for just one year. By contrast, Germany pays a mere 0.25%.
Italy has a lot of debt. It has had for years. But this has only become a problem now, because if Italy has to pay 6% interest on its debt, then its debts will grow more quickly than its economy's capacity to service them.
That is unsustainable, and investors know it. Which is why Italy may be about to cross a point of no return.
Once Italy's cost of borrowing rises above this level, it becomes very difficult to bring it down again.
Because at that point, investors know that Italy cannot repay its debts, which means they won't lend to Italy.
But once investors stop lending, then Italy cannot possibly meet the hundreds of billions of euros of debts that are coming up for repayment in the next few months.
So it becomes a self-fulfilling panic, just like a bank run.
Which is to say that, once Italy's cost of borrowing rises above, say, 7%, the chances are that it will just keep on rising as investors desert its bonds in their droves.
The boat will capsize.Misplaced pride
Meanwhile, Berlin's cost of borrowing has gone down and down as nervous investors have flooded into German government bonds.
Some Germans may take pride in this as a sign of strength, a vote of confidence.
In fact quite the opposite is true, because Germany is also part of the boat that is capsizing.
There is a common misperception that the eurozone crisis is all about debt.
It isn't. It is also about growth.
Any government can repay its debts, if its economy grows fast enough to generate the tax revenues needed.
But the current crisis is killing growth in Italy and Germany alike.
Businesses and consumers are nervous, and are cutting back their spending.
Europe's banks are finding it hard to borrow, and are being told to meet higher capital ratios - a measure of their financial prudence - so they are cutting back their lending.
Meanwhile, half the governments in Europe are finding it harder and harder to borrow, and in any case are being ordered by Brussels to cut back their spending to get their finances in order.
All of which is tipping the eurozone into a recession.
But a recession just makes debts even harder to repay - as has been amply demonstrated by Greece over the last four years.Keep pumping
What can be done?
In effect, panicky markets are offering to lend Germany money for free”
The best solution would be to have created a single eurozone government bond market in the first place. Too late for that, even if the Germans hadn't ruled it out anyway.
The eurozone instead hopes that its soon-to-be-1tn-euro bailout fund will do the job.
The fund is like a pump that will try to shift liquidity away from the dipping side of the boat (Germany) back towards the rising side (Italy and Spain).
But even if the pump is ready in time, most economists say it is not big enough to do the job.
Moreover, the eurozone already has a big pump in place, called the European Central Bank.
The ECB can print its own money, so there is theoretically no limit to how much Italian or Spanish government debt it could buy up.
But the central bank's new Italian head, Mario Draghi - perhaps under the influence of his more hawkish German colleagues - has ruled this option out.Old hat
The authorities could at least do more to head off the recession.
Depression-era economist John Maynard Keynes said there were two options - cutting interest rates and increasing government spending.
The ECB did indeed cut rates at its meeting on Thursday, but only by a quarter-point to 1.25%. It is an encouraging start.
And perhaps if interest rates reach zero, Mr Draghi can argue that the ECB must then follow its US and UK counterparts in resorting to quantitative easing - buying up government debt (including Italian debt) in order to help the eurozone economy (and not just to rescue his home country).
The problem is that lending more money only helps if the money gets spent. So ideally governments should also be spending more.
But only one government is able to borrow and spend on the scale needed - Germany.
Thanks to the crisis, Berlin can borrow so cheaply that the interest it pays would probably be less than the inflation rate.
In effect, panicky markets are offering to lend Germany money for free.
But Germany does not believe in Keynesian economics. It does not believe in borrowing and spending.
And this is what may ultimately sink the euro boat.