Merkel told: stop your dithering or euro crisis will spiral out of control

The European Commission's president last night urged bickering European leaders to solve the bloc's burgeoning debt crisis, and chided the German Chancellor Angela Merkel for what is increasingly seen as her weak and isolated position.

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With Greece teetering on the brink of a debt default and markets rapidly losing confidence in the eurozone's other weak economies, Jose Manuel Barroso asserted that "the time to act is now". In what was seen as a direct challenge to Ms Merkel – who has said there is unlikely to be an early resolution to the crisis – he added: "Don't tell us what you can't do; tell us what you can do."

The German leader was meeting President Nicolas Sarkozy in Berlin last night to hammer out a Franco- German strategy for the Brussels meeting, with France joining Mr Barroso in urging that a "strong signal" emerge from the summit.

But however stark and impassioned the plea, it is unlikely that Mr Barroso's call will be heeded amid the mayhem of last-minute negotiations.

A meeting of senior eurozone finance officials yesterday to pave the way for the summit was postponed until today, amid continuing negotiations over the terms of a second bail out for Greece.

A deal on the second package, worth €115bn (£101bn), is being held up by German demands for private-sector involvement. Although Berlin enjoys the support of the Dutch, who are equally keen to take the burden off their tax payers' shoulders, Ms Merkel is looking increasingly isolated. The European Central Bank has blasted the idea, arguing that this would trigger a default followed by a domino-like chain of events for the euro.

Under the latest plans, eurozone leaders may endorse a French idea to impose a tax on banks to meet German demands, though so far the proposal is light on substance.

"It's certainly not an easy solution," warns Guntram Wolff of Bruegel, an economics think-tank in Brussels. First of all, it's not just banks but pension and hedge funds that hold Greek debt and it's going to be very hard to subject them to a tax. And a general tax on all banks risks being unfair. Not all of them hold Greek debt."

Ms Merkel appeared to stymie the meeting' chances of success before it started yesterday, suggesting that a solution would be achieved only after lengthy negotiations.

"There is a great desire for a final, big step – at best it should be spectacular – but if you want to act responsibly you know that such a spectacular step will not happen," the Chancellor said. Mrs Merkel heads for today's crucial European Union summit with her domestic popularity plummeting; her plan for solving the debt crisis widely perceived as indecisive and under attack from all sides. Her opposition to the idea of re-structuring Athens's debt has also brought her into direct conflict with her government's own economic advisers.

Yesterday Germany's so-called "Five Wise Men" called for a partial Greek debt default and urged a discount of 50 per cent on the country's state bonds – meaning that investors would lose half of their stake. Eurozone leaders are also expected to tip-toe towards beefing up the Euro zone's bailout fund, or European Financial Stability Facility, in an attempt to rein-in contagion to other economies such as Italy and Spain and stabilise the banking sector.

Officials say the fund, which currently holds €440bn, could be allowed to extend credit lines to countries and to buy bonds on secondary markets. Although the idea was floated months ago by the European Commission, it still strikes fear in the hearts of many who see it as the first step towards a fiscal union. Mr Wolff said: "But there's no way around it, we need a centralisation of power in Europe."

Q&A: Why can't the leaders agree – and why should I care about it?

What is the aim of the summit?

In an ideal world they would agree on the terms of a new, circa €100bn, bailout for Greece, proposals on the long-term economic governance of the eurozone, and take some action to avert the contagion engulfing Italy and Spain.

Will it succeed?

No, and the German Chancellor, Angela Merkel, has already talked down the chances of the EU leaders delivering the "silver bullet" and warning that the summit will "not be a spectacular event". They will probably "kick the can down the road" again. Greece may not need the new money until September.

What are the options?

A complicated series of proposals that try to ensure that private-sector holders of Greek government bonds "share the pain" of a rescue and agree to devalue their holdings of Greek debt, to make it easier for the Greeks to pay it back and to reduce the burden on the rescue package. Thus, they might reduce the potential cost from over €100bn to say €80bn, but that would still be a substantial figure for the eurozone/IMF to find.

More radical options, unlikely to get too much serious attention from the EU leaders this time, include: pooling all the eurozone national debts into one large euro-bond pool; reducing the interest levied on the existing bailouts; having Greece leave the euro; Greece defaulting on its debts unilaterally; Germany leaving the euro; and a bank tax to help pay for new bailouts.

Who is preventing agreement?

Well, the Germans are holding out for the idea of getting the private-sector bondholders to share the pain and accept a longer repayment time or a lower interest rate; others, including the European Central Bank, are opposed to the idea, fearing that it still constitutes what is termed in the jargon "selective default", setting a bad precedent and triggering bank failures and financial chaos across the continent.

Unhelpfully, the credit ratings agencies have said that, even if the French banks, who hold much of the Greek debt, want to accept a reduction in value of those bonds, that would still constitute a selective default.

Why can't they agree?

The German government resents having to pay the entire bill for these bailouts and allowing bondholders of Greek debt to earn spectacular amounts of interest with little real risk.

Why should I care?

The IMF warned yesterday that a full-blown crisis might cost £400bn. As the Chancellor of the Exchequer said the other day, Britain is not immune to the crisis for a variety of reasons. First, even though our banks are now relatively strong, if they lend to French or German banks and they in turn have lent lots to Greece, then they will get caught up if the European financial system freezes up again. That, in turn, would prevent them lending to individuals and businesses as well as each other and damage the economy of Europe and beyond. That, in turn would slow growth and increase the pressure on governments who would have to rescue their stricken banks again – stretching some beyond breaking point. Second, the eurozone takes 50 per cent of our exports. Third, a Spanish or Italian sovereign debt crisis would quickly turn into a global problem, quite beyond the resources of the EU to fix. As a relatively small but open economy the UK is especially exposed to slowdown in world trade. A eurozone crisis, in other words, would almost certainly push the UK into a double-dip recession.

Should the UK help out?

Public opinion is obviously hostile to the notion, but there is a rational case for it, on enlightened self-interest grounds. Through our subscriptions to the IMF we would pay about 4 per cent of the IMF component of any new bailouts in any case, maybe 1 or 2 per cent of the total.

Sean O'Grady