It's the punch that you don't see coming that usually gets you and that is what has happened to the markets in both Europe and the United States.

The entire political class in Washington, and thus most of the media, focused intensely on whether the debt ceiling would be raised to avoid default. That was a mistake.

The real immediate threat wasn't default but the downgrading of U.S. debt, which has now happened just as world markets were already panicking. It is both a symbol of weakness and a psychological blow; a warning to investors looking for the traditional safe haven that the United States no longer looks quite so safe.

The real longer-term threat is the inevitable slowing of the U.S. economy that will follow the austerity program required by Congress, including the ending of long-term unemployment benefits and payroll tax relief, this looks like removing close to 2 percent of U.S. gross domestic product -- about $300 billion -- from the economy next year.

And while the entire political class in Europe has been focused on Greece and Spain and problems of sovereign debt, the real killer app for the euro has been lurking elsewhere. It is the payment system between the eurozone's central banks and it is heading for real trouble.

The problem is the inevitable result of the design of the eurozone, which likes to maintain the fiction that the member nations maintain financial independence so each retains its own central bank. In reality, the European Central Bank runs things by its control of interest rates and the money supply. But the ECB is sworn to the principle that one euro is as good as another and that Greek or Irish euros have the same value as German euros.

This means that when money flows from Irish banks to German banks, this appears in the national accounts as a liability of the Irish central bank to the Bundesbank. And since Germany runs a chronic trade surplus with almost all its European neighbors, the Bundesbank has run up more than $400 billion in credits from the central banks of Greece, Ireland, Portugal, Italy and Spain.

So long as the Bundesbank (and its auditors and the German courts) swallow the myth that a Greek or Irish euro is as good as a German euro, this process can continue. But when even the Spaniards and Italians have to pay 4 percent more in interest to borrow money than the Germans, the myth becomes hard to maintain. How long will the Germans believe it?

This is the real German bailout of its weaker partners in the eurozone. It is bigger than the combined rescue packages for Greece and Ireland and Portugal. And it is the bailout that few people outside the ECB and the Bundesbank noticed until recently.

But now the markets have begun to notice. And they are also learning that the problem isn't limited to Germany. Luxembourg has almost $100 billion in such intra-eurozone credits and Holland has another $60 billion.

The moment that any one of the eurozone central banks stops accepting such credits, declaring, in effect, that it doesn't trust that these Irish or Greek credits will be repaid in true currency, the eurozone falls apart. Its central myth, that one euro is as good as another, is seen to be false.

The easy availability of euro credits from the ECB has made all this much worse. Europe's banks are now addicted to them because this was the way to easy profits.

Imagine you are an Italian bank and you buy Italian sovereign bonds. You can then use these as collateral to borrow euros from the ECB for a tiny interest rate of 1.5 percent and lend the same money to commercial clients for 3 or 4 percent or even more.

It was never written down but there was a broad understanding across European finance that this would be the way Europe's battered banks would rebuild their capital and their balance sheets after the crash. The problem is that this created a dependence on short-term funding from the ECB and the Bundesbank (by far the biggest stake holder in the ECB) is getting nervous.

Then came last month's latest stress tests by the European Banking Authority and the small print noted that the 90 banks examined are going to have to refinance $7.6 trillion in debt over the next two years. That is almost half of Europe's total GDP.

Simon Johnson former chief economist at the International Monetary Fund, has pointed out that "in France, Italy, and Germany, the largest two banks alone need to roll over 6 percent, 9 percent and 17 percent of national GDP in debt, respectively, within 24 months."

Given the dubious quality of the collateral they are able to offer, private investors are unlikely to rush to lend banks the money (unless interest rates are very attractive). That leaves the ECB as lender of last resort, where the Bundesbank and the German government are already digging in their heels, knowing that the lender of last resort to the ECB is the German taxpayer.

So the reason why the world's stock markets are swooning isn't just that they see little future growth, with austerity cutting public spending in the Group of Seven countries and China reining in bank credit to tame inflation. It is because they fear a double-dip recession in the United States, thanks to Congress, and a banking crisis in Europe, thanks to the politics of the eurozone.

Tweet

Related Links The Economy