CNBC

Over the past couple of years, Europe has muddled through a long series of crunch moments in its debt crisis, but this September is shaping up as a "make-or-break" month as policymakers run desperately short of options to save the common currency.

Crisis or no crisis, many European policymakers will take their summer holidays in August. When they return, a number of crucial events, decisions and deadlines will be waiting.

"September will undoubtedly be the crunch time," one senior euro zone policymaker said.

In that month a German court makes a ruling that could neuter the new euro zone rescue fund, the anti-bailout Dutch vote in elections just as Greece tries to renegotiate its financial lifeline, and decisions need to be made on whether taxpayers suffer huge losses on state loans to Athens.

On top of that, the euro zone has to figure out how to help its next wobbling dominoes, Spain and Italy — or what do if one or both were to topple.

"In nearly 20 years of dealing with EU issues, I've never known a state of affairs like we are in now," one euro zone diplomat said this week. "It really is a very, very difficult fix and it's far from certain that we'll be able to find the right way out of it."

Since the crisis erupted in January 2010, the euro zone has had to rescue relative minnows in Greece, Ireland, and Portugal as they lost the ability to fund their budget deficits and debt obligations by borrowing commercially at affordable rates.

Now two much larger economies are in the firing line and policymakers must consider ever more radical solutions.

If Spain, the euro zone's fourth biggest economy and the world's 12th, loses affordable market financing the next domino at risk of falling is Italy — the euro zone's third biggest economy and a member of the G7 group of big wealthy nations.

A bailout of Spain would probably be double those of Greece, Ireland and Portugal combined, while Italy's economy is twice as large as Spain's again.

The European Union has already agreed to lend up to 100 billion euros ($123 billion) to rescue Spanish banks.

One euro zone official said Madrid has now conceded that it might need a full bailout worth 300 billion euros ($369 billion) from the EU and IMF [cnbc explains] if its borrowing costs remain unaffordable. European officials have spent the past few days issuing a series of statements declaring they will act to halt the crisis.

In the latest, issued on Sunday, Chancellor Angela Merkel and Prime Minister Mario Monti "agreed that Germany and Italy would do everything to protect the euro zone."

The wording was similar to remarks by European Central Bank chief Mario Draghi last week prompted buying in financial markets on the expectation that the bank would take steps to lower the cost of borrowing of Spain and Italy.

Deflating Life Raft

The euro zone does not seem to have enough cash in the current setup to deal with a scenario of Spain and Italy needing a rescue, and a sense of doom is growing among some policymakers. Fighting the crisis, said the euro zone diplomat, is like trying to keep a life raft above water.

"For two years we've been pumping up the life raft, taking decisions that fill it with just enough air to keep it afloat even though it has a leak," the diplomat said. "But now the leak has got so big that we can't pump air into the raft quickly enough to keep it afloat."

Compounding the problems, Greece is far behind with reforms to improve its finances and economy so it may need more time, more money and a debt reduction from euro zone governments.

If Greek debt cannot be made sustainable, the country may have to leave the euro zone, sending a shockwave across financial markets and the European economy.

Sept. 12 is a crucial date in the European diary. On that day the German Constitutional Court is scheduled to rule on whether a treaty establishing the euro zone's permanent bailout fund, the 500 billion euro ($616 billion) European Stability Mechanism (ESM), is compatible with the German constitution.

A positive ruling is vital, because Germany is the biggest funder of the ESM, and the euro zone would be powerless to protect Spain or Italy without the ESM. On the same day, parliamentary elections are held in the Netherlands where popular opposition to spending any more money on bailing out spendthrift euro zone governments is strong.

The Dutch vote may complicate talks on a revised second bailout for Greece, which also has to be agreed in September.

Athens wants two more years than originally planned to cut its budget deficit to below 3 percent of gross domestic product, so as not to impose yet more spending cuts on a country which is already in a depression.

This would mean Greece's 130 billion euro ($160 billion) second bailout package may need to be increased by 20 billion to 50 billion euros ($25 billion to $61 billion), according to estimates by some euro zone officials and economists, and there is no appetite in the euro zone to give Greece yet more extra money.

More importantly Greece needs to bring its debt, which is equal to 160 percent of its annual economic output, under control. This means euro zone governments, which own roughly two thirds of it, may need to write part of it off.

Private creditors have already suffered a huge writedown in the value of their Greek debt holdings but so far euro zone taxpayers have not lost a cent on any of the bailouts.

Last Chance Options

Policymakers are working on "last chance" options to bring Greece's debts down and keep it in the euro zone, with the ECB and national central banks looking at also taking significant losses on the value of their bond holdings, officials said.

If governments swallowed the bitter pill by also accepting a cut in the value of their contributions to loans already made to Greece, this would break a taboo and could provoke demands for similar treatment from Ireland or Portugal.

Peter Vanden Houte, chief economist at ING bank, said euro governments might be forced to accept a halving of the value of their Greek debt — known in the business as haircut.

"If Greece is to be saved, we must see some debt forgiveness from euro zone governments in the coming years because otherwise Greece is never going to come out of the situation it is in now," he said. "We are talking about potentially a 50 percent haircut, which would still mean the Greek debt would be (proportionately) around the euro zone average."

The euro zone would want concessions from Athens.

"Most probably in exchange, euro zone partners will be more strict on Greek compliance with structural reforms and may ask Greece to give up some sovereignty," said Vanden Houte.

While no official discussions are underway on another Greek debt restructuring, euro zone officials say privately it may be necessary if Greece is to have a fighting chance.

"The Greeks might say they are in such a mess that to survive they we need to ease up the austerity a bit, and to still regain debt sustainability they will have to default on 30 to 40 percent of the loans," one euro zone official said.

"There would be a lot of people saying this is understandable, so maybe this makes sense and maybe we could have a reasonable discussion among the member states on how Greece can move forward," the official said.

The official speculated that euro zone debt forgiveness for Greece could be made dependent on progress in structural reforms or that it could be reviewed once Athens has to start paying back the capital of the loans in 10 years.

"Maybe we could agree to give debt relief of, say, 25 percent to make possible some changes in the program. Then we implement that for six months or a year and maybe we find out that we need to give them another 25 percent and at the end of the day we might get to a stable situation," the official said.

The situation will become clearer once international lenders produce a new debt sustainability analysis for Greece at the end of August.

The Battle Of Spain

Preventing Spain and Italy from losing debt market access may require the crossing of another red line — ECB help in keeping down governments' borrowing costs.

Draghi signaled last Thursday the bank was ready to act, indicating it may revive its program of buying bonds of troubled governments on the secondary market.

"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," Draghi said. "To the extent that the size of the sovereign premia (borrowing costs) hamper the functioning of the monetary policy transmission channels, they come within our mandate."

However, Germany has always been hostile to the idea and the Bundesbank said on Friday that it continued to view it "in a critical fashion."

German Finance Minister Wolfgang Schaeuble dismissed suggestions Spain will ask the bailout fund to try to lower its borrowing costs by purchasing its bonds. Spain faces high borrowing costs because investors fear they will not get their money back.

The Spanish economy is shrinking, many of its autonomous regions need bailouts from Madrid and banks need the recapitalization of up to 100 billion euros ($125 billion).

Madrid still has to raise about 50 billion euros on the market by the end of the year. This may be impossible if its funding costs stay well above 7 percent for 10-year bonds.

Draghi's remarks knocked yields down by more than 40 basis points to below 7 percent on Thursday, but they could quickly climb back if the market does not see firm ECB [cnbc explains] buying soon.

The ECB also seems to be softening its stance on another taboo - giving the ESM a banking license so the fund can borrow from the ECB against euro zone government bonds.

If Spain or Italy applied for euro zone help in bringing down their borrowing costs, the temporary European Financial Stability Facility bailout fund or the ESM could help.

But with their combined firepower, under current agreements, of 459.5 billion euros until July 2013 and at 500 billion from July 2014, the funds do not have enough to impress markets.

If the ESM could refinance itself at the ECB, however, it would have virtually unlimited firepower for bond market intervention without causing inflationary pressure.

Discussions on the banking license for the ESM have been going on in the background for many months, officials said, with France openly calling for such a solution, but Germany, Finland and the Netherlands strongly against.