Investors are running to the safety of gold amid growing angst over the ability of European leaders to save Greece without endangering the entire euro zone.
The price of gold broke through $1,600 (U.S.) an ounce for the first time Monday and stocks tumbled worldwide as uncertainty gripped financial markets ahead of a key meeting of European leaders scrambling to contain Greece's debt crisis.
Greece, which is rapidly eating its way through last year's €110-billion ($150-billion) rescue, needs at least another €100-billion bailout to avert a default. Combined, the two packages would roughly equal Greece's annual economic output, highlighting the potentially enormous cost of ending the crisis.
European leaders are set to meet Thursday in an emergency summit. Leaders remain sharply divided over how to deal with Greece in a way that won't extend the problem to other heavily indebted countries, including Ireland, Portugal, Spain and Italy.
Many analysts have likened the European showdown to the 2008 decision by the U.S. government to let investment bank Lehman Brothers fail, triggering a global credit freeze because of the firm's key role in insuring bond defaults.
In Europe's wealthiest countries, tax payers don't want to pay for the excesses of neighbours who've been living dangerously beyond their means for years.
Germany and the Netherlands are insisting that private bondholders who lent Greece money should share the burden of the next bailout. But that could put the country in default on its bonds, potentially shifting the contagion elsewhere.
"Europe needs to pick its poison, between the principle of imposing pain on bondholders ... that are hated by Europe's politicians, versus much deeper contagion risk that could strike much harder at core members," Scotia Capital economist Derek Holt warned in a research note.
A stress test last week of European banks, which highlighted the fragile and interconnected nature of the euro area, has done little to calm fears.
Countries are tied to one other through broad holdings of government bonds by private banks. Eight banks failed the European Banking Authority test, which simulated a prolonged recession. Five of the banks are in Spain. Another 16 banks were precariously close to failing.
But the test assumed than none of the euro zone countries defaults on its debts - an outcome that many analysts now acknowledge may be inevitable.
Analysts say many more banks could suffer capital shortfalls if Greece and other governments were forced to default.
Francesco Garzarelli, Goldman Sachs's London-based chief interest rate strategist, said he's assuming Greece will wind up in "selective default" in any restructuring of Greek government bonds.
That, in turn, could make it more difficult for many European governments to roll over their debt as investors fret about eventually taking a haircut on what they're owed.
Already, investors are forcing countries such as Italy and Spain to pay much higher interest rates. Italian benchmark bond yields broke through 6 per cent Monday - the highest level since 1997. Spanish 10-year yields hit 6.39 per cent, up a full percentage-point in July.
The greater worry is what a default would mean for the future of Europe.
European Central Bank President Jean-Claude Trichet warned over the weekend that a default by Greece could destroy the underpinning of the euro zone. "If a country defaults, we can no longer accept as normal eligible collateral defaulted bonds issued by the government of that country," Mr. Trichet warned in a Financial Times interview.
Having defaulted bonds on its books would impair the ECB's ability to "be an anchor of confidence and stability," he added.
One way to resolve the crisis would be to issue special euro bonds, backed by all euro members and taking advantage of members with coveted triple-A credit ratings, such as Germany.
German officials, however, are worried about the moral hazard of bailing out bondholders, who willingly invested in Europe's more marginal countries. They are even more concerned about the politics.
"Nothing would destroy more quickly and in a more lasting fashion incentives for a solid budget policy [than]joint guarantees for sovereign debt," said Bundesbank President Jens Weidmann.
"The result would be European taxpayers, and first and foremost German ones, vouching for Greece's entire national debt. It would be a step towards a transfer union, something which Germany has correctly opposed thus far."
Mr. Weidmann pointed out that Greece is consuming more than it produces. "As long as there is no change here, restructuring won't help much," he said.