Germany vs the PIIGS

On Friday, Eurozone officials will meet at a summit to decide on possible treaty changes affecting the general makeup of the European Union.

Market commentators and euro officials alike have built up expectations for the summit, and many may be anticipating a form of a grand bargain that would alleviate the ongoing crisis in the Eurozone.

In an ideal world, Friday's summit would produce a powerful fiscal union that would alleviate investors' concerns and bring yields on European debt down permanently to sustainable levels.

However, that ultimate solution may fail to materialize.

The implementation would require a two-pronged approach—the issuance of common debt instruments (so-called Eurobonds) and a central mechanism of budget control.

Germany may oppose the first part of the package, as it would put its taxpayers on the hook for the profligate spending of the indebted PIIGS.

For their part, the PIIGS may oppose the second part of the package, as it would deprive their governments of a level of autonomy, taking the power of the purse away from their parliaments and sending it to Brussels.

If the conflict over those two issues can be resolved in an acceptable manner, then policy makers may be expected to move forward with a more powerful central European state.

France is somewhat in the middle of the situation. On the one hand, the country is AAA rated and its bonds have yet to fall under the level of scrutiny as those of the PIIGS.

On the other hand, most economists anticipate that France will soon be downgraded, and Standard & Poor's made that explicit on Monday, warning that it could downgrade France's sovereign rating by up to two notches in the coming weeks.

Thus, that may explain the various outlooks the countries have over Friday's summit.

On Wednesday, a French minister vowed that Friday's summit would produce a "powerful" deal.

Yet, a German official countered, stating that many players within Europe fail to grasp how dire the situation is, and warning that a grand deal may not be able to be reached.

Germany's Angela Merkel and France's Nicolas Sarkozy released a joint letter to the EU's president von Rompuy. In the letter, they pushed for a mechanism that would punish budget violators, but did not make any inroads towards a common form of debt issuance.

The euro traded lower against the US dollar on Wednesday, dropping as much as 0.30%. Depending on the outcome of Friday's summit, traders could anticipate a further drop in the shared currency, or a strong rally. Regardless, volatility could remain tremendous in the coming days.

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