European Central Bank is fighting fires on all fronts

Germany's chancellor Angela Merkel, Greece's PM George Papandreou, and France's president Nicolas Sarkozy. Photograph: Yves Herman/Reuters

Let's face it, another drop in investor confidence and another lurch downwards in stock markets, had been coming. The contributors were important: a weak report from US manufacturers; a quarrel between eurozone members over collateral to be used in the Greek bailout; and a warning from Morgan Stanley that the world is veering dangerously close to recession. But these worries are all underpinned by the sense that policymakers still haven't grasped the severity of the crisis.

The big fightback on Tuesday by German chancellor Angela Merkel and French president Nicolas Sarkozy was presented as a major shift in thinking. In one sense it was – a new "economic government" for Europe, imposing budget disciplines on member states, sounds terribly important (if other countries agree to sign up: no guarantees there). But it would have been more useful 10 years ago, before the debts were racked up and before southern Europe became uncompetitive with the north.

Last year's great hope was that growth in Germany would stir demand for goods from Spain, Italy and elsewhere; this year's reality is that even the German economy is in danger of stalling. Investors can see only two possible endings. Either Germany finds a way to underwrite the debts of the eurozone stragglers and thereby attempts to kick-start growth or it leaves the single currency. Until that choice is made businesses, consumers and investors don't know which way to jump.

Naturally, these tensions are now showing up in the banking system, where most of the sovereign debt is held. Perhaps the main factor behind the market chaos was the disclosure by the European Central Bank that it had provided a $500m facility to one bank. Are US banks becoming fearful of providing dollars to their eurozone counterparts?

If so, the ECB's promise to provide ample liquidity to the system will be tested. The central bank now finds itself fighting fires on all fronts. Worryingly, even as yields on US, UK, German and French 10-year bonds plunged again, those of Spanish and Italian bonds were moving in the opposite direction. The ECB needs the eurozone's politicians to make its life easier.