The eurozone has landed itself in a monetary version of Der Ring des Nibelungen, Richard Wagner’s cycle of operas, and doesn’t like it. The eurozone has landed itself in a monetary version of Der Ring des Nibelungen, Richard Wagner’s cycle of operas, and doesn’t like it.

The plot is familiar: The powers that be will come forth from the Halls of Valhalla in Brussels announcing that they’ve resolved the debt crisis with a new, surefire plan. For a while, the markets calm down and we get 30 minutes of dull recitative about the need for austerity. Then the Investment Valkyries realize that the latest solution is far from comprehensive, and continue selling Italian and Spanish debt. The more the plot develops, the more it appears to be foreshadowing the final defeat of the Euro Gods, the collapse of the Euro itself.

In all the Wagnerian drama of the Euro crisis, however, it’s easy to lose track of what’s actually going on, which is a lack of confidence — a problem that, if left uncorrected, threatens world financial stability.

The Greek debt crisis was caused largely by a bunch of investors deciding that the country, with its high debt load and structural problems, wasn’t a good credit risk. This led to a massive bond selloff, which caused the interest rate on Greek government debt to climb to the point that it became impossible for that government to finance itself. The other eurozone governments tried to cobble together a stabilization fund to help the Greek government, demanding tough austerity measures in return for the aid.

Greece served as a proving ground for the eurozone’s response to a pile of debt in other countries, and the lackluster results led to a loss of confidence in its ability to help other states on the southern periphery. Holders of Italian debt began to get nervous and sell Italian bonds, leading to higher bond yields and threatening the Italian government’s ability to borrow money and finance itself — in effect, it became Greece on a larger scale. If Italy goes over the cliff, having to borrow at high, unsustainable rates for a long period of time, the EU will not be able to help them — Italy is simply too big. This might lead Italy to either default on its debt or leave the eurozone to pay off the debt in a currency that it would control. This would have ripple effects, as many banks hold a lot of Italian debt. If that debt were to suddenly be worth less than it is today, a bunch of European banks will end up insolvent, and we’ll get the Crash of ’07 all over again. In this scenario, the world’s banking system ends up seriously screwed and the Euro falls apart, as other countries will rush to conduct their business in a currency that isn’t excessively strong relative to the new Italian currency, in order to allow these other countries to still export competitively to Italy.

So, how can the relatively solvent Euro countries prevent this chain of events from occuring? Three main proposals, unfortunately, are misguided: to issue bonds that are guaranteed by the full faith and credit of the more solvent countries like Germany to fund countries like Italy at lower interest rates; to set up a bailout fund that would ensure that owners of Italian debt feel confident that they’ll be paid back; or to have the European Central Bank print more money and use that to buy debt off threatened countries.

The problem with the joint-bond approach is that the Germans have good reason not to like it. It would appear to them that they’re sponsoring irresponsible spending on the southern periphery and playing the hardworking ant who spent the summer gathering food to the southern grasshopper who spent the summer doing nothing of the sort and now begs the ant for food during the winter. The Germans would accept the issuing of joint bonds on the condition that strict new rules are enacted that limit how much countries can spend and incur deficits. Such a loss of sovereignty would require a messy renegotiation of the EU treaty.

The problem with the bailout fund is that, in order for it to be big enough to cover Italy, it would have to use lots of financial leverage, just as Lehman Brothers relied on a lot of leverage. If that bailout fund doesn’t calm the markets and the assets continue to sink, this causes serious problems for the countries that contributed money or guarantees to the bailout fund. A failed bailout fund would have the potential to wreck the heretofore-healthy German government finances.

The problem with the ECB printing money in potentially unlimited quantities is twofold. First, it could lead to inflation, which would further push Europe into economic turmoil. Second, it could create a moral hazard problem: Member countries might be tempted to behave irresponsibly once they have guarantees of infinite money from the central bank.

For these reasons, none of the proposed schemes are likely to work, even if they are implemented. Instead, solutions for the eurozone contagion problem are in the hands of the troubled countries’ governments. This doesn’t necessarily spell disaster: In the wake of its own crisis, Ireland has done a commendable job taming investor worries. Mario Monti now leads Italy, which has a national-unity government at its helm. Monti is considered very capable, and the atmosphere of crisis and gravity might just persuade the Italian parliament to make the necessary reforms. Furthermore, despite having a high debt burden as a percentage of GDP, Italy is in much better shape financially than Greece. A lot of confidence is likely to be restored simply because the man Monti replaced, Silvio Berlusconi, was seen (not unfairly) as a buffoon. Italy also has the potential for faster growth if it can simply reform its sclerotic business environment, and this growth will go a long way towards restoring investor confidence. I think that Monti will be able to restructure Italy and gradually ease it away from crisis. If he isn’t, the Euro is doomed, despite the best efforts of Brussels and all the forces of Valhalla.

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