Instability and tensions continue to mount in Europe, mainly around sovereign debt and the solvency of its banking institutions. The choke point where most of the pressure piles up (until something breaks) is the fact that these overindebted sovereigns long ago sealed shut the traditional safety valve of last resort for sovereigns who can’t afford to pay back their debt: they traded their own floating currencies for a fixed exchange rate system, otherwise known as the Euro.

And so, after three years of Europe trying to paper over the growing cracks in the economic and monetary union, the EuroJenga blocks game continues, between the ECB, the various Eurozone governments, the IMF, the bond markets and the non-OECD surplus nations. After every turn, the tower is still standing, but it is inherently more unstable. In one of the latest rounds, the Merkel-Sarkozy plan called for bondholders to share in the burden of bailing out nations and banks. This led to the next turn in the EuroJenga Blocks game, which we dubbed The Return of the Stress, featuring the closure of bond markets for Irish banks and a jump in the bond yields of not just the PIIGS, but also other European sovereigns such as Belgium, Hungary, Austria and Romania, making the ECB the lender of only resort for most of Europe overnight. Angela Merkel’s turn again, and from the G-20 in Seoul she retracted clarified her earlier statement, explaining all this would apply only after 2013 under the new regime that will succeed the current temporary arrangements. To some this sounds like “Oh Lord, make me prudent and frugal, but not before 2013, Amen” which is a ludicrous stance for Europe’s economic powerhouse. But is it?

What if Merkel’s remarks were coldly calculated precisely to force the ECB into the breach? Clearly, with the spectre of deflationary collapse urging politicians to “do something”, unlimited Eurozone sovereign debt purchases by the ECB would let German banks off the hook and would also help Germany’s industry and economy indirectly via the ensuing devaluation of the Euro. This possibility was almost (but not quite) spotted by Simon Johnson in his essay Europe’s Monetary Cordon Sanitaire:

Given the vulnerability of so many eurozone countries, it appears that Merkel does not understand the immediate implications of her plan. The Germans and other Europeans insist that they will provide new official financing to insolvent countries, thus keeping current bondholders whole, while simultaneously creating a new regime after 2013 under which all this debt could be easily restructured. But, as European Central Bank President Jean-Claude Trichet likes to point out, market participants are good at thinking backwards: if they can see where a Ponzi-type scheme ends, everything unravels.

In effect, the European Union and the ECB are now being forced to return with overly generous support to the weak countries – including buying up all their debt, if necessary.

Why would Merkel and Sarkozy do a thing like that, which runs contrary to the “hard Deutschmark” – “hard Euro” philosophy around which the single currency was built? Well, there is one thing that Germany logically fears more than a soft Euro, and that would be a dead Euro plus the dissolution of the Franco-German axis, so it could be that Merkel had to compromise with Sarkozy who had threatened to leave the EMU in May unless the ECB agreed to start purchasing government bonds. In this latest episode of ratcheting of pressure by politicians against the ECB, the final straw for Merkel and Sarkozy may have been the imminent spectacle of President Obama’s drumming in the U.S. midterms.

From another angle, Merkel and Sarkozy’s move may be their own forced Euro-devaluing move in a much larger GlobalJenga Blocks game, one that is all about the Currency Wars and Emerging Markets, a type of cold war that is one level below a full blown mutually destructive trade war. After every turn, and provided the tower still stands, the player gains a temporary advantage, which is subsequently eroded as other players retaliate. In past turns, China has been unable or unwilling to let its currency appreciate, which is understandable given the standard U.S. play of exploiting its reserve currency status and printing dollars to finance, among other things, its voracious annual demand for imports ($2.4 trillion per annum) and its overextended military presence in 140 nations around the globe. In more recent turns, the U.S. has pulled out the Quantitative Easing blocks, resulting in the exporting of liquidity, inflation and currency appreciation to emerging markets. Given the Germans’ reputation for thoroughness and precision, it is possible that Merkel’s remark was not a “gaffe” but in fact her carefully executed turn in the game, that would give to her and to Germany a temporary advantage in both the EuroJenga Blocks and the GlobalJenga Blocks games.

There is one big problem in all of this. All games of Jenga end with a spectacular collapse of the tower, and in all cases the collapse begins from the most unstable level. How much self-inflicted deflation can distressed Eurozone sovereigns withstand before their cost/benefit analysis dictates that they should either default or seriously contemplate leaving the Euro, or both? How long can the undeclared “trade war by other means” continue before it erupts into a full-blown and globally recessionary protectionist trade war? The towers keep rising, and the turns are coming in faster and faster.

Something has to give, but in the meantime Lord Keynes maxim appears to hold true and fast as a beacon for all these hapless decision makers as they frantically rearrange the Jenga blocks: “In the long run, we shall all be dead.”