Germany got a lesson yesterday in the form of a stunningly weak take-up of its offer of Germany government bonds.  The lesson should be clear — the Euro is in trouble, and until the uncertainly clears so that investors know who is responsible for paying whose debts, ALL Euro-denominated investments will be viewed with suspicion.

The Euro has fatally blurred the difference between “core” and “peripheral” countries.  If decisions in Paris and Berlin determine the solvency of Portugal and Greece, then French and German credit is on the line even if peripheral countries default.

Right now, we do not know what the default lines are.  If Greece cannot pay its debts, who will backstop Greece, and the French and German and other banks holding Greek debt.  Will it be EFSF?  The ECB?  Or, in the end, the German treasury?

Germany has been holding a hard line, saying the ECB cannot print Euros and be the backstop of Euro debt without agreement from the German parliament.  Merkel has even been making noises about a new treaty to clarify the obligations of Eurozone members.

In my view, all this is prelude to a grand deal, in which Germany will agree to support the ECB acting as a true central bank/lender of last resort, and the Euro member countries will agree to outside supervision of their finances by a Eurozone inspector general type board, running largly by German-inspired rules.  This deal is likely to emerge by the end of this year or very early next year.

Such a deal is the necessary completion of the incomplete Euro structure, which blended 17 countries’ currency without creating a true central bank or fiscal oversight authority.  Such a deal is necessary to restore the Euro to full functioning in the face of the current slow-down.

But do not be fooled.  A deal will not magically restore the pre-2007 level of economic well-being.  A true economic crisis has occurred, and a decade of defaults and deleveraging lie ahead to restore fiscal health.  Harsh measures will still be needed to curb entitlement spending and stimulate growth, and another half-decade of slow growth for most of Europe is likely.  Still, slow-growth and clearing of debts is far preferable to uncontrolled chaos and widespread bank failures, so a deal will have to be made.