Spanish revolt brews as national economic rearmament begins in Europe

"We have reached the point where `taxes kill taxation'. The therapy is turning fatal and is starting to take on a highly political tone. Sixty years after the end of the war, Germany is again coming to be seen as an overbearing enemy, and an atmosphere of hostility is building up in a Continent divided between a rich and flourishing North and a South in danger of being reduced to a protectorate. If we carry on like this we are going to destroy the European project," he said.

The popular pressure gauge has been rising for months but the mass protests of the last two weeks have had a new and sharper edge -- even if you disregard the outbreak of violent street clashes with police in Valencia, already dubbed the "Valencia Spring".

A report last week by the Caritas wing of the Catholic Church warned that "there are more poor people than last year, and they are poorer. After four years of hardship, poverty is more widespread, more intense, and more chronic" than at any time in recent memory, with a gap between rich and poor that "threatens to polarize society". The poverty rate has risen to 21.8pc (38pc in Extremadura), the third worst in the EU after Romania and Latvia.

While the Greeks may or may not put up with ever-escalating EU demands -- most recently talk of parachuting 160 German tax collectors into the country -- any such treatment of Spain would set off the sort of `levantamiento' faced by Buonaparte in 1808, and the scale of damage to the European banking system would be catastrophic even for Germany.

The Spanish have good reason to feel maligned by North Europe's self-serving narrative of the EMU crisis. They never violated the Maastricht debt rules. They ran a budget surplus of 2pc of GDP during the boom.

Private credit spiralled out of control in part because the European Central Bank missed its inflation target every month for almost nine years and gunned the eurozone M3 money supply at double the bank's own target rate to help Germany, then in trouble.

Such a loose policy was toxic for an Iberian tiger economy, flooded with North European capital that it could not keep out under EU rules. Rates were minus 2pc in real terms for year after year, washing over the heroic efforts by the Bank of Spain to contain the damage.

Mr Rajoy has discretely requested a relaxation of the budget target to 5pc, pointing out `a la Grecque' that he inherited an even bigger shambles than feared.

Europe's answer has so far been iron inflexibility. “Backtracking on fiscal targets would elicit an immediate reaction by the market,” said ECB chief Mario Draghi -- a fiscal German, though a monetary Latin.

The Spanish must be sorely tempted to hurl sand back in the face of the ECB since the unforced errors of Frankfurt itself were the chief reason why the economies of Spain, Italy, and the rest of southern Europe buckled violently late last year.

The Trichet-Stark rate rises last year to “counter” the deflationary oil shock of the Arab Spring were as crass as it gets in central banking. Almost all prevailing scholarship warns against such a reflex. The rate rises compounded the fiscal squeeze already under way in the Latin bloc and led directly -- and inevitably -- to the collapse of the money supply in five or six countries.

By the end of 2011 all key measures of the money supply were contracting in the Euro zone as a whole. Hence an entirely avoidable Euroland recession. Hence the two-year economic slump now predicted by the IMF for Spain and Italy. Hence too an expected rise in Italy's debt/GDP ratio by seven points to 127pc by next year, and Spain's by eleven points, such is sensitivity of debt trajectories to growth rates.

Europe now faces another energy mini-shock as Iran pushes Brent crude to an all time-high in euros, tantamount to a €200bn tax on EMU consumers. Let us hope sense prevails this time.

Mr Draghi has done what he can to contain the damage from last year's tightening. His blast of unlimited three-year credit to banks at 1pc has averted a credit crunch as lenders frantically deleverage to cope with the EU's ill-judged pro-cyclical demand for 9pc core Tier 1 capital ratios by June.

But the Draghi Bazooka is a very blunt form of quantitative easing and contains the seeds of its own failure since it is leading to structural subordination of unsecured creditors and a concentration of systemic risk as the weakest banks load on the sovereign debt of the weakest states. Once again, the ECB is tying itself in knots -- and engaging in legal tricks to circumvent the Lisbon Treaty -- because Germany will not let it carry out plain-vanilla transparent QE that is perfectly legal and arguably necessary to keep nominal GDP growth on an even keel.

Ultimately, politics will decide the matter, and Mr Rajoy is not alone in Europe. He has a champion in Italy's Mario Monti, de facto leader of the Latin bloc and increasingly the man in whom the US, Japan, the IMF, and the rest of the world, are investing their hopes. As Mr Borrell put it, he is the only European statesmen with enough credibility to confront Angela Merkel "face to face".

Mr Monti's joint letter with twelve EU states last week calling for an end to self-defeating contraction marks a key moment in this crisis. If Francois Hollande is elected French president in May, the shift in Europe's balance of power will be complete. Germany will lose its stifling grip on EU policy machinery. The EMU bloc will start to tilt towards reflation at long last.

Whether it can come soon enough to avert a social explosion across Europe's arc of depression remains to be seen. Nor can such stimulus overcome the fundamental flaws of EMU since Germany is at an entirely place in the deform structure, with unemployment at 20-year lows of 5.5pc.

What is needed to save the South must endanger the North. Germany would overheat, pushing its inflation to 4pc or 5pc until Bild Zeitung erupts in Teutonic fury. It is impossible to reconcile the conflicting imperatives.

My guess is that Germany's refusal to countenance any form of EU subsidies, debt-pooling, or fiscal union -- other than policing the budgets of captive states -- has definitively broken the EMU spell. Latin nations by increasingly regard talk euro of solidarity as humbug. It has been a nasty shock. The era of national economic rearmament in Europe has begun.

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Time to swim against the tide and dip into Europe again

For investors as well as journalists, where the funds are actually flowing tells a tale, even if it is more often than not a contrarian one. Investing in the places no-one else wants to go is psychologically hard but frequently profitable.

The fund flow data so far this year confirm a marked shift in investor sentiment. A net $16bn (£10bn) – inflows minus outflows – has returned to the world's stock markets, reversing about 9pc of last year's outflows, according to Citi figures.

More interesting is where the money is heading. It has been pouring into emerging markets and out of developed markets, with the exodus from the mature markets accelerating in the past couple of weeks. In total, emerging markets have attracted $24bn, offsetting about half of last year's redemptions, while developed markets have seen $8bn taken off the table. In particular, investors have been least interested in European and Japanese equities as their appetite for the developing regions of the world has returned.

It is probably not too surprising that these are the two markets to have been left out in the cold. Japan has been a disappointment while making the case for Europe has been mission impossible since the Greek crisis flared up two years ago. It is a statement of the blindingly obvious that Europe continues to face some pretty intractable problems. But investment is less about spotting where things are going right or wrong than about noticing where the perception of those trends is at odds with the reality. However bad things are, investors can profit if the market thinks they are worse than they turn out to be.

That is the gist of the argument for investing in Europe today, or as Credit Suisse put it this week: "Europe – lots of problems but raise to benchmark". It is the first time the bank has been anything but negative on the region in two years.

Here are some of the problems for investors in Europe. First, growth is anaemic and, with wages in the peripheral countries needing to fall by as much as 13pc to restore the periphery's competitiveness, it is likely to continue to stagnate. Second, the process of paying down debts has barely begun – another reason to expect weak growth. Third, several governments outside the core look insolvent. Fourth, the euro remains grossly overvalued, which in turn crimps growth.

Against this backdrop, it is unsurprising that investors have shunned the region. Even less surprising when you consider the inability of the eurozone's political leaders to convey any sense that they either understand the scale of the challenge or can find a solution. So why might Europe, nevertheless, be worth a look now? First, because the risk of a disorderly break-up of the eurozone now looks lower than a few months ago. ECB President Mario Draghi's injection of long-term liquidity for the region's banks has made a Lehman-type credit crunch possible rather than probable.

Second, because manufacturing new orders are picking up and earnings forecast revisions are second only to those in the emerging markets and better than in the US, UK and Japan. When European earnings revisions have turned before, the region's shares have tended to outperform over the next three to six months.

Third, because European companies have a significant exposure to the faster-growing markets in the rest of the world. Many of the large, multi-national businesses that dominate most European investment funds are tied to the fortunes of the global economy and not just the eurozone area. Just over half of continental European earnings come from outside the region.

Finally, and most importantly, valuations are attractive on a historical basis. Dividend yields, in particular, are in many cases approaching 5pc, which is around 50pc higher than the average in Europe in recent decades and more than twice the yield on German government bonds. Compared to the rest of the world, the valuation of European shares has not been this attractive for around 16 years.

If successful investing was about following the herd and doing what felt easiest, we would all be good at it. Unfortunately, the rewards accrue to those who swim against the tide and invest when it feels most uncomfortable. Perhaps this is just such a moment in Europe. "Don't follow the money," as Deep Throat didn't say.

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Workers of Europe unite, you've only euro chains to lose

Almost 97pc of the European Union’s population is now governed by conservative or Right-leaning coalitions, or EU-imposed mandarins. All that is left to social democrats is Austria (8.4m), Denmark (5.5m), and Slovenia (2.1m).

The whole machinery of the European Union (EU) system is under the control of the Right, with variants of Rhenish corporatism in the Council, and pre-modern Hayekians at the European Central Bank (ECB). Whether you regard this Hegelian ascendancy as good or bad, it certainly has profound consequences.

For just as former Prime Minister Margaret Thatcher protested at Bruges that “we have not successfully rolled back the frontiers of the state in Britain, only to see them reimposed at a European level”, the Left might equally protest that they have not fought the long, hard struggle for worker rights in their own democracies to see social welfare rolled back by Brussels and Frankfurt.

In Italy, EU viceroy Mario Monti has more or less been ordered to reform the labour code, to break union power by shifting to “firm-level” wage deals and rewrite Article 18 that protects workers against sacking for economic reasons – the issue that led to the assassination of two labour reformers by the Red Brigades since 1998.

No doubt Italy should confront its trade unions if it hopes to compete in the world, but my point is a different one. Who decides such matters? Why would the Italian Left think it desirable to concentrate further power in EU hands when it will without question be used against them? They might win control of Italy. They have no chance of taking control of policy levers in Europe in the foreseeable future, if ever.

David Begg, head of the Irish Congress of Trade Unions, said his encounter with the (EU-ECB-IMF) Troika now restructuring Ireland was a sobering experience.

“The man from the IMF was very helpful, but the officials from the EU were neo-liberal ideologues. We had a very fraught meeting, almost a shouting match,” he said. “It would have been better if we had never have joined the euro.”

The consequences of this Rhenish Right ascendancy in EU institutions – not the same as Anglo-Saxon or Burkean “small platoon” conservatism, by the way – was in evidence at the Merkozy summit in Brussels. As the BBC’s Paul Mason put it, the deal has “outlawed expansionary fiscal policy” by enshrining near-zero structural deficits in international law, with constitutional debt brakes, mandatory sanctions and budget commissars for delinquent nations.

The 26 states that went along with this Merkel plan have given up the right to pursue counter-cyclical Keynesian stimulus, and have agreed to do so in perpetuity since it is almost impossible to repeal EU “Acquis”.

Personally, I am not a Keynesian – nor are many Daily Telegraph readers – but this strikes me as a mad commitment to make. For the Left it is surely an unmitigated disaster. They cannot pursue their economic agenda ever again. Fabians feared long ago that such an outcome was built into EMU. They called the euro a “bankers’ ramp”, but somehow their warnings were drowned out in the mass hysteria of monetary union.

Owen Jones at the New Statesman said it is baffling that socialists have been so slow to recognise the threat. “The proposed EU treaty is perhaps the biggest catastrophe to befall the European Left since the Second World War. After this stitch-up, the Left really needs to have a long, hard think about its attitude to the EU as it is currently constructed. There’s still a sense that any criticism of the EU puts you in the same box as swivel-eyed Ukip-ers. It is a travesty that highlighting the EU’s palpable lack of democracy has become a Right wing issue.”

Well, yes, we’re all swivel-eyed now. It should indeed have nothing to do with Right wing or Left wing affiliation. Besides, if you listen closely, angry talk is simmering across Europe, in the ranks of the French socialist party, in Germany‘s Linke, in Italy’s Rifondazione, and Spain’s newly-liberated Socialist Workers Party (PSOE).

Note the outburst last week by Pedro Nuno Santos, socialist vice-president in Portugal’s Assembleia. “We have an atomic bomb that we can use in the face of the Germans and the French: this atomic bomb is simply that we won’t pay. Debt is our only weapon and we must use it to impose better conditions. We should make the legs of the German bankers tremble,” he said.

The sacrosanct 40-hour week is being stretched to 42 hours in Portugal. Manuel Carvalho da Silva, head of the General Confederation of Portuguese Workers, said pay-cuts for public workers under successive austerity packages will amount to 27pc.

This is an “internal devaluation” of epic proportions.

Much has been written in recent weeks of Europe’s swing to the far Right, of the rise of Geert Wilders in Holland, or Marie Le Pen’s Front National in France, or – quite different – the black-shirt Garda Magyar of Hungary’s Jobbik party. The echoes of the 1930s are loud, and will become louder as combined monetary and fiscal contraction entrench depression.

Yet there is another parallel of equal resonance: the election of the Front Populaire in France with Communist support in May 1936, the cathartic rejection of deflation policy. Whether or not Leon Blum privately wanted to leave the Gold Standard – that inter-war replica of Europe’s unemployment union – the logic of his policies forced the outcome. Orthodoxy was overthrown.

The question for today’s Left is whether it is in their interests to keep apologising for an EU monetary regime that has pushed the jobless rate for youth to 49pc in Spain, 45pc in Greece, 30pc in Portugal and Ireland, 29pc in Italy and 24pc in France – yet 8.9pc in undervalued Germany – and that offers no credible way out of the slump for the Southern half.

Comrades across Europe, come over to the eurosceptic side. You have only your euro chains to lose.

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Should the Fed save Europe from disaster?

Unless Germany agrees to the full mobilization of the European Central Bank very fast, the eurozone will spiral out of control. As The Economist put it, “The risk that the currency disintegrates within weeks is alarmingly high.”

Theoretically, EMU can limp on though the Winter until the Italian debt auctions of €33bn in the last week of January, and €48bn in the last week of February. The reality is that sovereign contagion to the financial system may well bring matters to a head more swiftly.

If break-up occurs in a disorderly fashion, with Club Med states and Ireland spun into oblivion one by one, the chain reaction will cause an implosion of Europe’s €31 trillion banking nexus (S&P estimate), the world’s biggest and most leveraged. This in turn risks an almighty global crash – first class passengers included.

So the question arises, should the rest of the world take over management of Europe to prevent or mitigate disaster? Specifically, should the US Federal Reserve assume leadership as a monetary superpower and impose policy on a paralyzed ECB, acting as a global lender of last resort?

In essence, the US would do for EMU what it did in military and strategic terms for the Europe in the 1990s when Washington said enough is enough after squabbling EU leaders had allowed 200,000 people to be slaughtered in the Balkans. The Pentagon settled matters swiftly with “Operation Deliberate Force”, raining Tomahawk missiles on the Serb positions. Power met greater power.

Personally, I have not made up my mind about the wisdom of a Fed rescue. It is fraught with dangers, and one might argue that resources are better deployed breaking EMU into workable halves with minimal possible damage.

However, debate is already joined – and wheels are turning in Washington policy basements – so let me throw this out for readers to chew over.

Nobel economist Myron Scholes first floated the idea over lunch at a Riksbank forum in August. "I wonder whether Bernanke might not say that `we believe in a harmonized world, that the Europeans are our friends, and we know that the ECB can't print money to buy bonds because the Germans won't let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them'. It is something to think about," he said.

This is not as eccentric as it sounds. The Fed’s Ben Bernanke touched on the theme in a speech in November 2002 – “Deflation: making sure it doesn't happen here” – now viewed as his policy `road map' in extremis.

"The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt. Potentially, this class of assets offers huge scope for Fed operations," he said.

Berkeley’s Brad DeLong said it is time for Bernanke to act on this as the world lurches straight into 1931 and a Great Depression II. “The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash,” he said.

The Fed could buy €2 trillion of EMU debt or more, intervening with crushing power. The credible threat of such action by the world’s paramount monetary force might alone bring Italian and Spanish yields back down below 5pc, before one bent nickel is even spent.

One presumes that the Fed would purchase both the triple AAA core and Club Med in a symmetric blast of monetary stimulus across the board, avoiding the (fiscal) error of targeting semi-solvent states. In sense, the Fed would do quantitative easing for the Europeans, whether they liked it or not.

David Zervos from Jefferies has proposed an extreme variant of this, accusing Germany’s fiscal Puritans of reducing Europe’s periphery to “indentured servants” and driving the whole region into depression with combined fiscal and monetary contraction.

“We in the US need to snuff out these sado-fiscalists and fast, they are a danger to the world. The US can force monetisation at the ECB. We should back up the forklift and buy Euro area bonds. Lots of them,” he said.

Some of the purchases could be achieved by tapping the Fed’s euro account at the ECB, flush with funds as a result of currency swaps provided by Washington to help Europe shore up its banks. Ultimately mass EMU bond purchases would cause a sudden and potentially dangerous spike in the euro against the dollar. There lies the rub. If the ECB failed to loosen monetary policy drastically to offset this, the experiment could go badly wrong.

A pioneering school of “market monetarists” - perhaps the most creative in the current policy fog - says the Fed should reflate the world through a different mechanism, preferably with the Bank of Japan and a coalition of the willing.

Their strategy is to target nominal GDP (NGDP) growth in the United States and other aligned powers, restoring it to pre-crisis trend levels. The idea comes from Irving Fisher’s “compensated dollar plan” in the 1930s.

The school is not Keynesian. They are inspired by interwar economists Ralph Hawtrey and Sweden’s Gustav Cassel, as well as monetarist guru Milton Friedman. “Anybody who has studied the Great Depression should find recent European events surreal. Day-by-day history repeats itself. It is tragic,” said Lars Christensen from Danske Bank, author of a book on Friedman.

“It is possible that a dramatic shift toward monetary stimulus could rescue the euro,” said Scott Sumner, a professor at Bentley University and the group’s eminence grise. Instead, EU authorities are repeating the errors of the Slump by obsessing over inflation when (forward-looking) deflation is already the greater threat.

“I used to think people were stupid back in the 1930s. Remember Hawtrey’s famous “Crying fire, fire, in Noah’s flood”? I used to wonder how people could have failed to see the real problem. I thought that progress in macroeconomic analysis made similar policy errors unlikely today. I couldn’t have been more wrong. We’re just as stupid,” he said.

Needless to say, reflation alone will not make Euroland a workable currency area. Nor will fiscal union, Eurobonds, and debt pooling down the road.

"Even if they do two years of fiscal transfers, and the ECB buys all the bonds, and the problems are swept under the carpet, we are still going to be facing a crisis at the end of it," said professor Scholes.

None of the “cures” on offer tackle the 30pc currency misalignment between North and South, the deeper cause of this crisis. What Fed-imposed QE for Euroland can do is make a solution at least possible stoking inflation deliberately.

This means inflicting a boomlet on the German bloc, while allowing the South to take its fiscal punishment without crashing further into self-defeating debt deflation. It forces up prices in the North, compelling the neo-Calvinists to accept their share of the intra-EMU price readjustment.

The Germans will not like this. If inflation causes them rise up in revolt and leave EMU to the Latins, so much the better. That is the best solution of all.

What we know for certain is that Europe’s current policy settings must lead ineluctably to ruin and perhaps to fascism. Nothing can be worse.

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So far, but so safe to relax and we are in danger of being pushed to Europe

Portugal denied EU pressure for a rescue operation but markets did not believe them.

Nature at two speeds on the continent were drawn clearly traders on their screens - countries where bond yields are fall (and rise in the price) and those where yields continue their relentless travel upwards where obligations prices fall as investors turn their back on countries financing needs.

Italy and the Spain dislike the concept of "devices" nation, but in terms of funding, they are moving in this direction, join the Ireland, the Portugal and the Greece. Spanish and Italian bonds risk premia were pushed yesterday at their highest levels since the euro was born in 1999.

Sovereign debt crisis becomes a self-sufficient, daytime phenomenon as bond investors refused to believe these Governments claiming political rhetoric from does not need to bail. Their lack of support just exacerbates the problem, the European Central Bank and the international monetary Fund help inevitable.

Without full and credible deficit reduction plans, appearing on politically unpalatable, countries such as the Portugal will be forced into Ireland in reality even more unpleasant to accept a bailout.

By this stage a country facing long-term and permanent damage as it takes even more debt but is supported by an economy struggling to grow or to decline.

At United Kingdom yields gilt 10 years encouraged by once again 3 2pc, continuing the theme of the United Kingdom considered a safe haven. This is partly due to the fact that UK debt has already average maturity 14 years compared to eight in savings in distress and significantly on our credit 80pc is occupied by institutions national as UK pension funds, ready for greater stability on the market.

But we cannot be complacent. Monday with the Agency the responsibility of the budget (TBO) forecasts show that our annual discovered is £ 148. 5bn or 10pc of GDP. Public sector net debt will hit £ 923bn or 61pc GDP.

The fact that investors are comfortable with these record levels of debt is because our policy has changed and we plan credible claims, at least for our annual discovered which is scheduled for the fall to £ 18bn or 1pc of GDP by 2015. However, public sector net debt will continue to rise over the next five years as our annual, although falling, is added to the stack of our total debt exceeded. By 2015, compared to the 923bn £, reach 1.3 trillion of £.

But the powers of market are other obsession tirelessly in Europe are only outstanding here because investors believe our assumptions that budgetary consolidation, reform of welfare and released for the growth of the private sector will make our still precarious equilibrium finance.

For the moment at least, response to serious problems of our own is in our hands, but no sign of convenience by the coalition on our finances and apparent contagion in Europe is rapidly surround us, too.

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ECB tightens noose on Southern Europe

Jean-Claude Trichet, the ECB's president, brushed aside warnings that tightening at this delicate juncture might push Spain and Italy into the danger zone, insisting that every eurozone country stands to lose if the ECB fails to anchor price stability. Inflation risks "remain on the upside", he said, using coded language that opens the door to further rate rises over the Autumn.

As expected, the ECB waived its collateral requirements on Portuguese bonds, clearing the way for the country's banks to continue tapping the ECB's liquidity window following Moody's downgrade of Portugal's debt to junk. The ECB has already waved the rules for Greece.

Unlike Anglo-Saxon peers, the ECB is unwilling to gamble that inflation will fall back after spiking to 2.7pc in June on fuel and food pressures. But the hardline policy contains its own risks.

Yields on Italian 10-year bonds rose to a post-EMU high of 5.21pc yesterday. Spanish yields reached 5.71pc before settling down slightly. The bond jitters follow a slew of grim data pointing to an economic relapse in both countries.

"The debt problems are contained in Spain and Italy for now but the eurozone is dealing with finer and finer margins," said Simon Derrick, currency chief at the BNY Mellon.

"The situation is magnitudes worse than where we were a few months ago and the global outlook is following the pattern of mid-2008 before the Lehman crisis, so people are getting nervous," he said.

Italy's finance minister, Giulio Tremonti, unveiled a draconian plan yesterday to balance the budget by 2014 and stay a step ahead of the bond vigilantes, warning of "disaster" unless €48bn of cuts were passed. "What is at stake is the survival of civil society in this country," he said.

With low private debt, Italy has managed to stay out of the maelstrom so far. However, its public debt is the world's largest after the US and Japan at €1.84 trillion. The upward creep in yields has begun to attract unwelcome attention, notably among Asian investors.

Hans Redeker, currency chief at Morgan Stanley, said the danger for the eurozone is that long-term investment inflows have dried up. They have been replaced by a growing reliance on hot money funds, attracted by Europe's higher rates.

"This money is fickle. It will move out on the slightest sign of trouble. Europe's capital flows are sounding alarms," he said. By raising rates, the ECB may have made matters worse.

Mr Trichet emphatically opposed any form of selective default on Greek debt, fearing that it could scare away investors and set off fresh contagion in the eurozone. "We say, no, full stop," he said.

Europe's political leaders have the ultimate say however and they are hardening their stance on private sector "burden sharing". The Dutch finance minister, Jan Krees de Jager, told The Daily Telegraph that it would be "very difficult" to secure voluntary participation from the banks so other methods will be needed.

"We are exploring several possibilities. If we continue down the current road, all private debt in Greece will be converted into sovereign debt and we will have bailed out the banks," he said.

The ECB has the unenviable task of trying to bridge the North-South gap with a single interest policy. Germany's industrial machine is powering ahead on exports to China, Russia, and the Mid-East; while Spain seems trapped in near-depression, with unemployment at 21pc.

The ECB's monetary tightening has asymmetric effects, with greater impact on heavily-indebted and rate-sensitive economies in Spain and Ireland than on core Europe.

Over 90pc of Spanish mortgages are priced off the floating 1-year Euribor rate, which has risen 66 basis points to 2.19pc this year. Only 20pc of German loans are on floating rates.

Rate rises are ratcheting up the pressure as each month a fresh cohort of Spanish households sees a sharp upward adjustment in their mortgage payments. There is a hangover of 680,000 unsold properties on the market, according to government figures.

"There is no sign of recovery," said Raj Badiani from IHS Global Insight. "House sales are falling again at double-digit rates and if this spills over into 2012, the pressure on the Spanish banking system could become unbearable," he said.

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Europe declares war on rating agencies

 Politicians have denounced Moody's drastic downgrade of Portuguese debt as an act of financial vandalism. Photo: BLOOMBERG

Wolfgang Schauble, German finance minister, said there was no justification for the four-notch downgrade or for warnings that Portugal might need a second bail-out. "We must break the oligopoly of the rating agencies," he said.

Heiner Flassbeck, director of the UN Office for World Trade and Development, said the agencies should be "dissolved" before they can do any more damage, or at least banned from rating countries.

Moody's downgrade late on Tuesday set off immediate contagion to Ireland, with dangerous ripple effects across southern Europe. Yields on Irish two-year bonds surged above 15pc of the first time. Italian borrowing costs reached levels not seen since the aftermath of the Lehman crisis in late 2008. Yields on Spain's 10-year bonds jumped 12 basis points to 5.59pc.

The renewed jitters chilled the torrid summer rally on global bourses. The FTSE 100 slipped 21 points to 6,002, while Milan fell 2.4pc. A quarter-point rate rise in China added to the mood of caution, capping commodity gains.

David Owen, of Jefferies Fixed Income, said concerns are growing the crisis could spread to bigger economies as growth falters across Europe's southern arc. "The risk of cross-over into Spain and Italy is very serious. The fear is what will happen if Spanish 10-year yields rise above 5.7pc and stay there for a few weeks. Spain also has €2.5 trillion of private sector debt, and a rise in rates risks pushing the country into recession."

Portugal's new premier, Pedro Passos Coelho, said Moody's downgrade was a "punch in the stomach" at a time when the new government has done everything demanded by the EU/IMF inspectors.

The rating said it had little choice once EU leaders began to insist on "burden sharing" for private holders of Greek debt, raising the spectre of default. It is almost certain any Greek formula will be extended to Portugal.

The European Central Bank has cautioned EU leaders from taking a hard line on private creditors, warning it would destroy confidence among the very investors needed to fund Europe's deficits. The net effect would be destructive. This is exactly what has occurred.

The Institute of International Finance (IIF) representing 400 global banks has floated the idea of a bond "buy-back" on a voluntary basis that would help Greece lower its debt burden, but this has not been enough to satisfy German demands for more creditor pain.

The IFF said yesterday it was studying a "menu of options to help Greece", including variants of a complex French plan for debt rollovers. The original plan was widely deemed too harsh on Greece.

Jose Manuel Barroso, the European Commission president, questioned Moody's motives and said it had fanned the flames of "speculation" with an unwarranted downgrade. "It seems strange there is not a single rating agency coming from Europe. It shows there may be some bias in the markets when it comes to the evaluation of the specific issues of Europe," he said, seemingly unaware that Fitch Ratings is French-owned.

The Commission is drawing up laws to clamp down on the agencies. These will now be tougher. "Developments since the sovereign debt crisis show we need to take a further look at reinforcing our rules," said Mr Barroso.

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Mounted world as China stock market slide raises rates Asia following United States, less Europe

Nikkei average of Japan more 2pc slipped and briefly touched a low interday a month on Wednesday as investors rushed to take profits. Photo: Reuters

Japan focused on exports was the hardest hit by the Nikkei index in Tokyo tumbling 1. 7pc tp 9371 points.Australie the ASX slipped 0. 7pc and Hong Kong Hang Seng 0. 6pc.

Oil prices rose above $ 80 per barrel, after attempting to China to control inflation and a property bubble prospective he dragged more than 4pc Tuesday.

The dollar edged more after that Treasury Secretary Timothy Geithner is pulled out of a strong dollar fell against the yen, the euro and the pound sterling.

Buck the trend, with ABN Korea Southern progress 1pc and Shanghai Composite 0 6pc increasingly China markets.

"China's announcement was a great surprise to the market.Attenuated sense throughout Asia as investors worried that an increase in interest rates could pressure on economic growth in China, "says Masatoshi Sato, market analyst, Mizuho investors securities in Tokyo."

Bank of China said that it will be Wednesday increase loan Yuan a year to 5 5 31pc 56pc and yuan year drops 2 5pc 2 25pc rates.

The increase in interest rates was the first to China since 2007.

Chinese economy has increased 10 3pc in the second quarter and its growth has propelled the resumption of the economy of a deep recession, while the United States and Europe struggle to return to economic works foot.

The US Federal Reserve should largely in an attempt to revive the flagging economy in November by launching a program to purchase more .the Treasury bonds ' objective would be to drive down interest rates on mortgages, loans and other debts and encourage Americans to spend.

Mervyn King, Governor of the Bank of England has also fed hopes to facilitate greater quantitative (ve) Tuesday when he says political currency continues to be a "powerful weapon" in support of recovery.

New York by the tumbling points 165.07, Dow Jones industrial average or 1. 5pc 10,978.62, fall below 11,000 for the first time in a little over a week .the ' broader S & P 500 index lost 18.81 points, or 1. 59pc 1,165.90 points.

Rich technology Nasdaq composite index shed 43.71 points, or 1 76pc 2,436.95 points, as Apple is 2 7pc on earnings as forecast estimate and IBM dropped 3 4pc due to a decline in new contracts.

In Europe, FTSE 100 has fallen from London, 0 6pc, DAX 0 the Germany 4pc France ACC 0 7pc.

FTSE 100 Great Britain has been opened 10 - 19 points lower on Wednesday, mirroring the weakness of global investors concerned about interest rates Chinese and cooled US mortgage bonds also viewed UK policy.

The minutes of the Bank of England is published at 9.30 a.m. and Chancellor announced review of expenditures at 1230.

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EMU policies are pushing Southern Europe into systemic political crisis

This is what happened to Britain during the ERM crisis of 1992, the trial run for the monetary union.

German reunification was an "asymmetric shock", setting off a boom that compelled the Bundesbank to tighten the screw again and again, and forcing the Bank of England to follow suit at a time when the UK housing bust was already underway.

Spain is about to relive the experience, for Germany is going through another such shock. This one is caused by surging exports to the BRICs -- machinery, luxury cars, aircraft, medical kit, and chemicals. German exports to China rose 40pc last year, and 42pc to Russia.

Oddly, perhaps, I am not seriously worried about Ireland. It has a dynamic manufacturing and export service base, and can hope to export its way back to health. The fact that Ireland has required an EU-IMF rescue should not be misread as evidence that it is in worse shape than several others. Banking busts are desperate but not serious, as the saying goes.

The less open economies of Greece, Spain, and Portugal will find it more of a struggle to recover. The IMF says Portugal’s current account deficit will still be 9.2pc of GDP this year (and 8.4pc in 2015, if it is possible to defy gravity for so long), Greece will be 7.7pc, and Spain 4.8pc.

That these deficits should be so high two or three years into a slump shows how hard it will be to turn this crisis around. Meanwhile, The Netherlands will have a surplus of 6.8pc, and Germany 5.8pc.

The structural misalignment is grotesque, like the perma-divide between Italy’s North and South but without the vast annual subsidies that stops it blowing up.

A full 140 years after the Two Sicilies were gobbled up into Cavour’s lira zone, convergence has not occurred. The Bourbons might have done better.

Already reeling, the indebted European periphery must now brace for a fresh shock as the European Central Bank tightens monetary policy to stop Germany from over-heating.

One-year Euribor rates used to price Spanish mortgages have been creeping up for months, and jumped to 1.54pc after Jean-Claude Trichet turned seriously hawkish on inflation last week. It may go much higher very fast if the ECB starts to raise rates by the middle of this year.

This will not help clear a four-year backlog of unsold homes in Spain, which is no doubt why Madrid is pushing for a capital injection of up to €80bn into the smaller banks and cajas – by partial nationalization if necessary.

The central bank said in November that the banks have €181bn (£153bn) of "potentially problematic" loans to the real estate sector, or 17pc of GDP.

Mr Trichet’s fire-breathing rhetoric can be taken as a signal that the ECB will continue to run monetary policy for German needs and tastes, refusing to accommodate a little slippage on inflation to let Club Med regain lost competitiveness without having to endure the agony of debt-deflation. Indeed, the ECB seems to have picked up some of the worst habits of its mentor.

Mr Trichet is no doubt in an impossible position because the German people gave up the D-Mark under an implicit and sacred contract that EMU should never lead to inflation in their country. Should it ever do so, acquiescence in the whole project comes into question.

Yet Mr Trichet's comments on Thursday were astonishing. He cited the ECB’s rate rise in July 2008 with approval – and as a warning -- as if this monetary Charge of the Light Brigade had been vindicated by events. Most economists viewed that decision as best forgotten.

We now know that large parts of the eurozone were already in recession by then, that the commodity spike was burning itself out, that ECB rhetoric had set off a destructive dollar rout and pushed the euro to ruinous highs of $1.60, and that the foundations of the credit system were already crumbling.

A paper by the Richmond Fed suggests that ECB’s action was a key trigger of the global crisis.

The ECB is now itching to tighten again, this time because of a temporary jump in headline inflation to 2.2pc, caused by rising oil and food prices. No matter that M3 supply growth in the eurozone is anaemic at 1.9pc.

Real M1 deposits have contracted at a rate of 2.8pc over the last six months in the quintet of Italy, Spain, Greece, Ireland and Portugal.

"This is comparable with the decline in early 2008 just ahead of the plunge into recession," said Simon Ward from Henderson Global Investors.

The ECB has passed the eurozone debt parcel back to EMU governments, deeming it the proper responsibility of fiscal authorities to sort out the mess.

So be it. Since the only government that seems to matter in our new German Europe is in Berlin, the parcel has in reality been handed to Chancellor Angela Merkel.

She has two viable options. She can choose to save monetary union, first by doubling the size of the EU bail-out fund and halve the interest rate charged so that the debt-stricken states can recover; and then by acquiescing in fiscal federalism and a pooling of debts -- what McKinsey’s chief in Germany calls a "spiral into a Transferunion" – entailing a regime of subsidies for years to come.

That is to say, Germany must be prepared to do for Southern European what it has already done for its own kin in East Germany, but on six times the scale.

Or she can pull the plug, by quietly signalling to the Verfassungsgericht that Berlin would not be too angry if the eight judges declared the EU’s rescue machinery to be unconstitutional, ending EMU as we know it.

What is clear is that status quo is ruinous. The slow suffocation of nations still under Fascist rule just one generation ago cannot end well for liberal democracy in Europe.

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Europe fears motives of Chinese super-creditor

The exact role of China is unclear. Chinese vice-premier Li Keqiang promised to buy Spanish debt during a visit to Madrid last week, reportedly up to €6bn (£5bn).

China was the secret buyer in a private placement of €1.1bn of Portuguese debt last week, according to the Wall Street Journal. Finance minister Fernando Teixeira dos Santos said China "may well have been" a key buyer in this week's debt auction.

China was not the only force at work. Traders say the European Central Bank (ECB) acted aggressively behind the scenes, calling some 20 dealers to buy Portuguese debt in the secondary market.

This created what amounted to a "short-squeeze" in Portuguese bonds just before auction, causing spreads to tighten dramatically and inflicting damage on market makers acting in good faith. City sources say this has caused some bitterness.

Charles Grant, head of the Centre for European Reform and author of a book on EU-China relations, said China's top goal is to secure an end to the EU arms embargo, imposed after the Tiananmen Square massacre in 1989. It rankles as humiliating treatment for a global superpower that has since changed profoundly.

The EU has refused to move on the sanctions until China ratifies the International Covenant of Civil and Political Rights, and China's arrest of Nobel peace dissident Liu Xiaobo has further complicated matters.

Yet Brussels has suddenly begun to shift gear. Baroness Ashton, the EU's foreign policy chief, said the embargo is damaging EU-China ties and called for new thinking to "design a way forward".

Mr Grant said Britain, France and Germany are all wary of giving ground, cleaving closely to US policy. Washington views China's growing military might as a strategic threat to the Pacific region. There have already been hot words over the South China Sea, and the Pentagon claims that China has an "operational" ballistic missile able to sink aircraft carriers at long range.

A WikiLeaks cable from the US embassy in Beijing last January cites the EU's mission chief, Alexander McLachlan, saying Spain had tried to curry favour with Chinese leaders, "seeking advantage at other EU states' expense". He said China was fully aware of Madrid's game but was exploiting intra-EU divisions to gain leverage.

China's second goal is to secure market economy status from the EU. This would make it much harder for the EU to impose anti-dumping measures against Chinese imports. As it happens, the EU has just lifted its punitive tariff on Chinese shoes.

Mr Grant said Beijing will not risk much cash to woo Europe. "They are very hard-nosed. They may splash some money around for goodwill but they are not going to waste the hundreds of billions that may be needed. Nothing short of meaningful action by Europe's leaders can genuinely stabilise the eurozone," he said.

China's sovereign wealth funds, including the central bank's exchange fund SAFE, have been severely criticised at home for losing money on US investment banks during the credit crisis, or on dollar losses from US Treasury debt. They will be careful about fresh risks in euroland.

"It is debatable whether China would actually be willing to become buyer of last resort of the debt of a country close to default," said Julian Jessop from Capital Economics. "Chinese officials are acutely aware of past losses and will not want to be seen to risk their peoples' capital on a lost cause. Their actions frequently fall short of expectations raised by their words."

Simon Derrick, from the Bank of New York Mellon, said that China must find somewhere to recycle its fresh reserves or lose control of its own currency. It is already sated with US assets. Holdings are 65pc in dollars, 26pc in euros, 5pc in sterling and 3pc in the yen.

"They may start buying some emerging market bonds but basically the only place they can go is into euros, and buying €6bn of Spanish debt is a good investment if it helps protect their other euro assets," he said.

Mr Derrick said Beijing appears to take the view that the ECB's monetary policy is fundamentally more rigorous than the money-printing ventures of the US Federal Reserve. "The Chinese have made it clear that they don't see any meaningful shift in US policy."

In the global beauty contest, Europe's debt still looks less ugly than the main alternative.

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Europe stumbles blindly towards its 1931 moment

“If that is not enough to worry about financial contagion, what is? The ECB's lack of action begs the question as to whether it is fulfilling its financial stability mandate,” he said. That is a polite way of putting it.

The eurozone’s fiscal fund (European Financial Stability Facility) is fatally flawed. Like Alpinistas roped together, an ever-reduced core of solvent states are supposed to carry the weight on an ever-widening group of insolvent states dangling beneath them. This lacks political credibility and may be tested to destruction if – as seems likely – Ireland is forced to ask for help. At which moment the chain-reaction begins in earnest, starting with Iberia.

It was a grave error for Germany’s Angela Merkel and France’s Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder “haircuts” at this delicate juncture, ignoring warnings from ECB chief Jean-Claude Trichet that such talk would set off investor flight from high-debt states.

EU leaders have since made a clumsy attempt to undo the damage, insisting that the policy shift would have “no impact whatsoever” on existing bonds. It would come into force only after mid-2013 under the new bail-out mechanism. Nobody is fooled by such a distinction.

“This is a breath-taking mixture of suicidal irresponsibility and farcical incoherence,” said Marco Annunziata from Unicredit.

“If by 2013 countries like Greece, Ireland and Portugal are still in a shaky position, any new debt issued will carry exorbitant yields. The EU would then have to choose between a full-fledged, open-ended bail-out, and reneging on the promise that existing debt would not be restructured. Will German voters then accept higher taxes to save their profligate neighbours?” he said.

In May it was enough for the EU to announce a €750bn safety-net with the IMF for eurozone debtors. Bond spreads narrowed. A spike in economic output - led by Germany’s rogue growth of 9pc (annualised) in the second quarter – beguiled EU elites into believing that monetary union had survived its ordeal by fire. It had not, and this time they will have to put up real money.

Sadly for Ireland, events have snowballed out of control. Confidence has collapsed before Irish export industries – pharma, medical devices, IT, and backroom services – have had time to pull the country out of its tailspin.

Premier Brian Cowen – who presides over a budget deficit of 32pc of GDP this year - still insists that no rescue is needed. “We have adequate funding right up until July,” he said. Mr Cowan must know this is not enough. Funding for Irish banks has evaporated, and with it funding for Irish firms.

As we learn from leaks that “technical” talks are under way on the terms of any EU bail-out, it can only be a matter of weeks, or days, before Ireland has to tap EFSF – for €80bn to €85bn, says Barclays Capital.

Portugal is in worse shape than Ireland. Total debt is 330pc of GDP. The current account deficit is near 12pc of GDP (while Ireland is moving into surplus). Portuguese banks rely on foreign wholesale funding to cover 40pc of assets.

The country has been trapped in perma-slump with an over-valued currency for almost a decade. Successive waves of austerity have failed to make a lasting dent on the fiscal deficit, yet have been enough to sap the authority of the ruling socialists and revive the far-Left.

Former ministers are already talking openly of the need for an EU-IMF rescue. It is hard to see how Portugal could avoid being sucked into the vortex alongside Ireland. Europe and the IMF would then face a cumulative bail-out bill of €200bn or so. That stretches the EFSF to its credible limits.

The focus would shift instantly to Spain, where economic growth stalled to zero in the third quarter, car sales fell 38pc in October, a 5pc cut in public wages has yet to bite, and roughly 1m unsold homes are still hanging over the property market. The problem is not the Spanish state as such: the Achilles Heel is corporate debt of 137pc of GDP, and the sums owed to foreign creditors that must be rolled over each quarter.

The risks are obvious. Unless core EMU countries raise fresh funds to boost the collateral of the rescue fund, markets will not believe that the EFSF has the firepower to stand behind Spain. Will Germany’s Bundestag vote more funds? Will the Dutch? Tweede Kamer, where right-wing populist Geert Wilders now holds the political balance, adamantly opposes such help, and might well use such a crisis to launch a bid for power.

It is far from clear what would happen if Italy was forced to provide its share of a triple bail-out for Ireland, Portugal and Spain. Italy’s public debt is already near danger point at 115pc of GDP. It is also the third-largest debt in the world after that of Japan and the US. French banks alone have $476bn of exposure to Italian debt (BIS data).

While Italy has kept a tight rein on spending, it is not in good health. Growth has stalled; industrial output fell 2.1pc in September; and the Berlusconi government is disintegrating. Four ministers are expected to resign on Monday.

It is clear by now that IMF-style austerity and debt-deflation is not a workable policy for the high-debt states of peripheral Europe, since it cannot be offset by the IMF cure of devaluation. The collapse of tax revenues has caused fiscal deficits to remain stubbornly high. The real debt burden has risen further.

The ECB is the last line of defence. It can halt the immediate Irish crisis whenever it wishes by buying Irish bonds. Yet instead of pulling out all the stops to save monetary union, the bank is winding down its emergency operations and draining liquidity. It is repeating the policy error it made by raising rates into the teeth of the crisis in July 2008.

Yes, the ECB is already propping up Ireland and Club Med by unlimited lending to local banks that then rotate into their own government debt in an internal “carry trade”. And yes, the ECB is understandably wary of crossing the fateful line from monetary to fiscal policy by funding treasury debt.

Bundesbank chief Axel Weber might fairly conclude that it is impossible at this stage to reconcile the needs of Germany and the big debtors. If the ECB prints money on the scale required to underpin the South, it would set off German inflation, destroy German faith in monetary union, and perhaps run afoul of Germany’s constitutional court. If EMU must split in two, it might as well be done on Teutonic terms.

All this is understandable, but is Chancellor Merkel really going to let subordinate officials at the ECB destroy Germany’s half-century investment in the post-war order of Europe, and risk Götterdämmerung?

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Europe unveils sweeping plans to govern reckless banks

 'Banks will fail in the future and must be able to do so without bringing down the whole financial system' Photo: EPA

The European Commission’s "Framework for Bank Recovery and Resolution" draws on Scandinavia’s hard-line approach during their banking crises in the early 1990s. The goal is to end the pattern of moral hazard and mispricing of risk that generated Europe’s debt woes.

"Banks will fail in the future and must be able to do so without bringing down the whole financial system," said Michel Barnier, the internal market commissioner Mr Barnier’s consultation paper will lead to a "legislative proposal for a harmonized EU regime" as soon as this summer, with an insolvency structure in place by 2012.

The final phase will be the creation of a European Resolution Authority by 2014, adding a fourth pillar to the EU’s new architecture of financial regulation. EU "authorities" typically have their own permanent staff and powers to override national bodies.

The document said regulators should be given "statutory power" to write down senior bank debt, by any amount necessary, or to convert debt into equity. "Such a power would only apply to new debt (or existing debt contracts renewed or rolled over) after entry into force of the power."

Worries over the exact shape of the bondholder haircuts caused credit default swaps on senior European bank debt to rise sharply earlier in the day, with the Markit iTraxx Senior Financials index rising 16 basis points to 196.

Spanish and Italian banks were hit hard, among them Banco Santander, with some lenders in the eurozone periphery at even higher levels than during Europe's so-called "Lehman moment" last May.

The jitters spread to sovereign debt as well. The CDS on Portugal rose 25 points to 525, Ireland rose 18 to 630, Belgium rose 17 to 240, and Spain rose 13 to 350.

The EU plan would apply to all classes of senior debt, with authorities given leeway to act on a case-by-case basis, depending on systemic risk. Some trade creditors and counterparties in swaps and derivatives contracts may be shielded under specific circumstances.

There would be a strict ranking of creditors. "Equity should be wiped out before any debt is written down, and subbordinated debt should be written down completely before senior debt holders bear any losses," said the document. Bonds would be bound by contracts giving the authorities power to impose losses once a "trigger" is activated.

The plans allow oversight bodies to place a "permanent presence" of inspectors in the offices of suspect banks, adopting a scheme already pioneered by Spain’s central bank. There will be annual stress tests, geared to shocks of "low probability but high impact".

Regulators will be able to order bank boards to fire directors, desist from any activity, reduce leverage, sell off assets, or restructure debt.

In extreme cases, they will have pre-emptive powers to take over the entire bank and decapitate top management, perhaps when Tier I capital ratios fall below an fixed level. Stronger banks will be required to help cover the costs of failure by weaker peers, creating a further buffer between the financial industry and the taxpayer.

Mr Barnier, a former French foreign minister and Savoyard ski enthusiast, has worked closely with the authorities in the UK, where similar plans are already under way. Britain is the first of the big EU states to introduce a resolution mechanism.

There were widespread concerns a year ago that Mr Barnier would pursue a "French agenda" to cut the City of London down to size, but he has since won plaudits as a man who genuinely wishes to bolster Europe’s leading financial hub – though on a sounder footing. Jonathan Faull, his right-hand man as director-general, is a British EU official of free-market views.

The concern for bondholders is that the screws may be tightened further as Germany and other states alter the text to alleviate populist pressures at home, or that the decision to seize banks and impose haircuts will become politicized. It is unlikely that either EU ministers or the European Parliament would go so far as to penalise existing debt, which might be construed as retroactive. The legal complications would be enormous.

Mr Barnier has to walk a fine line, doing enough to deter moral hazard without going so far as to cause investor flight from EMU bond markets. His paper says that creditors should be treated fairly, with scrupulous consistency, and in conformity with European rights law. But at the same time, the document recognises that it is hardly healthy if funding costs in Europe are held down "artificially".

Much grief might have been avoided if the EU had created this machinery long ago, before launching monetary union.

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Germany defiant as Europe suffers

Yields on 10-year Spanish bonds rose briefly to 5.6pc on Wednesday.

Bond traders say the country may have trouble raising funds until it becomes clear whether the European Central Bank will buy Spanish debt.

In continued tension across the eurozone periphery, rioters in Athens set fire to cars and beat a former minister with clubs outside the parliament building.

The violence follows ugly scenes in Rome the day before when protests over education cuts erupted into street battles, leaving 100 injured in Italy’s worst riots for 30 years.

One police officer was nearly dragged to his death. Italy’s press said urban guerrillas had infiltrated the protest, prompting fears of a return to the 1970s terrorism of Left and Right.

More peacefully, Ireland’s Dail approved the country’s €85bn rescue deal by six votes but anger is building over the terms. Investors fear that the next government will repudiate the deal after fresh elections.

Michael Noonan, finance chief of opposition Fine Gael, said Ireland should walk away from the senior debt of rescued banks.

“You have the obscene situation where the poorest of the poor, through their taxes and welfare cuts, are being asked to guarantee the speculation of investors in hedge funds. Ireland has no moral or legal obligation to cover this debt,” he said.

Brian Lenihan, the finance minister, accused Fine Gael of playing with fire. “Those who think we can unilaterally renege on senior bondholders against the wishes of the ECB are living in fantasy land,” he said.

In Berlin, the Merkel government so far shows no sign of wanting to play the good European.

Foreign minister Guido Westerwelle issued a veiled threat that Germany may walk away from the project if the rest of the EU tries to bounce the country into a debt union. “Anyone who talks about entering a union of financial transfers is putting support for Europe at risk, especially in the countries that must bear most of the burden,” he said.

Germany’s political elite is bitterly divided about how to handle EU demands.

Social Democrat leader Frank-Walter Steinmeier accused Mrs Merkel of a “pathetic abdication” of her duties.

“This is no answer to the deepest European crisis in my lifetime,” he told the Bundestag.

He said Europe must lance the boil once and for all. “Greece, Ireland and Portugal urgently need to be released from a substantial part of their debt. Painful spending cuts ... will not allow them to escape their debt trap.

“We must also ensure that solvent member states, such as Spain and Italy, are not drawn into the downward spiral of financial speculation. We must guarantee the entire outstanding eurozone debt of stable countries,” he wrote.

Germany’s opposition has just committed itself to a policy that would saddle the country with up to €4 trillion of fresh liabilities, a repeat of German reunification on a much bigger scale. This is a radical departure.

Mr Steinmeier’s proposal is a gamble that Spain (or Italy) would never need to draw such support. It assumes that Spain is fundamentally solvent. This is a hotly disputed subject.

Former Chancellor Helmut Schmidt said Germany must give up much of its sovereignty to the EU and accept the burden of costly “reparations” if it is to save the euro and avoid pushing southern Europe “into the abyss”. He said Germany had caused “horrors in the past” and had a special duty to uphold the European ideal. Petty-minded “tacticalists” who seem willing to let the EU fall apart will leave a catastrophic historical legacy, he said.

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Warning shot for America and Europe as S&P downgrades Japan

In contrast to Europe, Japan has barely started to tighten its belt, drifting on with a budget deficit that will be 8pc of GDP as far out as 2013. "This is not affordable. Japan is running out of the domestic financial assets to absorb the debt," said Mr Ogawa.

Japan's population has been contracting since 2005, pioneering a fate that awaits much of Europe and Asia. Its median age is a world record at 44.4 years, and rising fast. The population will fall from 127.5m to 89.9m by 2055, according to Japan's Social Security Resarch Institute. "Despite this bleak demographic outlook, Japan has no specific measures or plans to deal with its diminishing and aging population," said S&P.

Japan was downgraded repeatedly between 1998 and 2002 without suffering much harm but that was in a different world, before the global credit crisis shattered illusions about the sanctity of sovereign debt.

The Bank for International Settlements has warned that simmering fiscal problems in the rich countries are nearing "boiling point", with a risk of an "abrupt rise" in bond yields as investors choke on excess debt.

Kaoru Yosano, Japan's economy minister, called S&P's decision "regrettable" given that the government is working on a plan to overhaul the tax and social security system. "I hope the world will understand our sincere efforts to carry out fiscal consolidation. I believe confidence in Japan will not be shaken."

Mr Yosano himself said last week that Japan has reached a "critical point" where investor patience might suddenly snap. "We face a dreadful dream that one day the long-term interest rate might rise."

Mr Jessop said the S&P downgrade is no shock since the country was already on negative watch. However, the Democratic Party of Japan – hampered since June by a hung parliament – has not yet shown that it is "up to the job" of restoring discipline.

"If the government gets this wrong, Japan could be the first Asian casualty of the global financial crisis. Markets have tolerated Japan's awful fiscal position because it was the fastest growing economy in the G7 last year, thanks to a rebound in exports and fiscal stimulus. But it all started to go horribly wrong in the fourth quarter when the economy almost certainly contracted again," he said.

Adarsh Sinha from Bank of America said Tokyo is on borrowed time but does not expect a bond crisis this year. "Inexorable structural forces mean that each year brings us closer to when the domestic pool of saving will be insufficient to finance Japan's public debt. However, 2011 is unlikely to be the tipping point for this disorderly adjustment."

Tax revenues covered just 52pc of spending in 2010. Almost half the budget was borrowed. Even in the boom year of fiscal 2007 revenues covered only 70pc of outlays, so the problem is clearly chronic and not caused by the recent recession.

The IMF's latest Article IV report on Japan warns that without a shift in policy the "public debt-to-revenue ratio" will rise from 263pc three years ago to 482pc by 2015. No country in peacetime has ever pushed the fiscal boundaries so far and emerged unscathed.

Peter Tasker from Arcus Research, a venerated Tokyo expert, said horror stories about Japan's debt have been the stuff of folklore for years, yet borrowing costs have fallen ever lower anyway because the country is "entirely self-financing". If need be, the Japanese can squeeze a lot more tax from their under-taxed economy.

"Rather than a 'dreadful dream', Japan's leaders face an enticing reality. They have the opportunity to issue more and more bonds at the lowest interest rates seen since the Babylonians invented accounting. Japan needs to forget about the views of credit agencies, which have not had a terribly good track record recently," he wrote recently.

Japan has certainly been shielded from global vigilantes so far because 95pc of its debt is held by local investors, allowing Tokyo to issue 10-year bonds at just 1.21pc. It is far from clear that this can continue. The Government Pension Investment Fund (GPIF) – the biggest holder of Japanese debt – has switched from net buyer to net seller as it meets payout costs for retiring baby-boomers.

Dylan Grice, a noted Japan bear at Societe Generale, said the country's ageing crisis would bite in earnest in two to three years, causing pensioners to run down their assets. The savings rate has already dropped from 15pc of GDP in 1990 to under 3pc. It may soon turn negative, depleting reserves needed to soak up state debt.

"They will have to turn to foreign investors, who will demand higher yields of 4pc to 5pc. The government will not be able pay this because interest payments are already 28pc of tax revenues," he said.

"If they try to correct it by a fiscal contraction [raising taxes] they will cause a depression that dwarfs anything in Greece. The Japanese are facing a problem that no country has ever faced before. I think Japan is already is beyond the pale," he said.

Mr Grice predicts the get-out-of-jail-free card will prove to be some sort of stealth default through inflation, perhaps spiralling into hyperinflation very fast once the genie is out of the bottle.

James Bullard, the head of the St Louis Federal Reserve, said recently that the US is "closer to a Japanese-style outcome today than at any time in recent history". That bears thinking about.

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Mounted world as China stock market slide raises rates Asia following United States, less Europe

Nikkei average of Japan more 2pc slipped and briefly touched a low interday a month on Wednesday as investors rushed to take profits. Photo: Reuters

Japan focused on exports was the hardest hit by the Nikkei index in Tokyo tumbling 1. 7pc tp 9371 points.Australie the ASX slipped 0. 7pc and Hong Kong Hang Seng 0. 6pc.

Oil prices rose above $ 80 per barrel, after attempting to China to control inflation and a property bubble prospective he dragged more than 4pc Tuesday.

The dollar edged more after that Treasury Secretary Timothy Geithner is pulled out of a strong dollar fell against the yen, the euro and the pound sterling.

Buck the trend, with ABN Korea Southern progress 1pc and Shanghai Composite 0 6pc increasingly China markets.

"China's announcement was a great surprise to the market.Attenuated sense throughout Asia as investors worried that an increase in interest rates could pressure on economic growth in China, "says Masatoshi Sato, market analyst, Mizuho investors securities in Tokyo."

Bank of China said that it will be Wednesday increase loan Yuan a year to 5 5 31pc 56pc and yuan year drops 2 5pc 2 25pc rates.

The increase in interest rates was the first to China since 2007.

Chinese economy has increased 10 3pc in the second quarter and its growth has propelled the resumption of the economy of a deep recession, while the United States and Europe struggle to return to economic works foot.

The US Federal Reserve should largely in an attempt to revive the flagging economy in November by launching a program to purchase more .the Treasury bonds ' objective would be to drive down interest rates on mortgages, loans and other debts and encourage Americans to spend.

Mervyn King, Governor of the Bank of England has also fed hopes to facilitate greater quantitative (ve) Tuesday when he says political currency continues to be a "powerful weapon" in support of recovery.

New York by the tumbling points 165.07, Dow Jones industrial average or 1. 5pc 10,978.62, fall below 11,000 for the first time in a little over a week .the ' broader S & P 500 index lost 18.81 points, or 1. 59pc 1,165.90 points.

Rich technology Nasdaq composite index shed 43.71 points, or 1 76pc 2,436.95 points, as Apple is 2 7pc on earnings as forecast estimate and IBM dropped 3 4pc due to a decline in new contracts.

In Europe, FTSE 100 has fallen from London, 0 6pc, DAX 0 the Germany 4pc France ACC 0 7pc.

FTSE 100 Great Britain has been opened 10 - 19 points lower on Wednesday, mirroring the weakness of global investors concerned about interest rates Chinese and cooled US mortgage bonds also viewed UK policy.

The minutes of the Bank of England is published at 9.30 a.m. and Chancellor announced review of expenditures at 1230.

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