FORTUNE — It may seem like the euro crisis is on hold at the moment as European lawmakers take their summer vacations. But upon their return in September, they will almost certainly find that their house is still very much on fire.
A number of policy decisions will be made in the next month that could alter the direction of the crisis, from establishing the European Central Bank’s new role as “bond-buyer-in-chief” to figuring out how to bail out Greece yet again. There are a number of large hurdles the ECB will need to hop over before the markets accept that it is in control of the chaos.
But all eyes will be on Berlin for at least one day next month as the German constitutional court rules on the constitutionality of the nation’s participation in Europe’s new bailout fund. If the court rules against German participation, panic will almost surely sweep through the markets as the core of the rescue operation fizzles before it is even able to get off the ground.
Mario Draghi, the head of the ECB, took to the stage at the beginning of August to reassure the markets that he would do everything in his power to save the euro. He was followed by German chancellor Angela Merkel who echoed similar sentiments from her perch in Berlin. The strongly worded statements were supposed to instill confidence, despite the fact that neither gave concrete answers as to how they would go about backing up their statements. Nevertheless, traders and money managers gave them the benefit of the doubt and agreed to what has amounted to a sort of “timeout” in the crisis. All parties then packed their bags for the Mediterranean, the Hamptons or the Cape as the eurozone remained alight.
But it is now time to think about what’s next for the euro. Fund managers and government officials will be returning in September to what appears to be a hopeless situation. The ECB has tried to reassure Wall Street and the City publicly and through backchannels that they have a plan in place that will make it easier for cash-strapped eurozone members to borrow enough money to meet their debt obligations.
What exactly the ECB will do to calm investor fear is one of the biggest question marks going into September. From what Draghi has said so far, it seems he wants to put Italy and Spain, the current bad boys of the crisis, in what amounts to be a eurozone twelve-step program. The first thing would be for both of them to finally admit that they have a problem and to seek financial help from the two bailout funds set up by the eurozone – the already established EFSF and the coming ESM. Once they do that, then they can apply for help from the ECB.
The nature, the timing and the conditions attached to that help is the main mystery here. Rumors and speculation will hang over the market until September 6th when the ECB gets together to talk about their strategy. The help will most likely come in the form of some sort of permanent bond-buying mechanism by which the ECB would become the buyer of last resort for eurozone debt, but more specifically, Spanish and Italian debt.
As you may recall, this isn’t the first time the ECB will be intervening in the markets in such a fashion. They first started buying up Spanish and Italian debt last year as yields reached critical levels for both countries. But the ECB stopped buying bonds earlier this year, noting that the program was supposed to be an emergency fix, not a permanent solution to the crisis. Since then bond yields in both countries have drifted back up to critical levels as investors demand a high premium to hold on to their debt. Indeed, Spanish debt bounced about the critical 7% level several times since then, forcing it to cancel debt auctions and really tighten its belt.
But belt tightening won’t work with the level of debt both nations have on their books. Spain looked like it was better off than most nations but the central government in Madrid has had to take on the liabilities of Spain’s troubled regions and its insolvent banks. Italy has made great strides in reforming its antiquated and dysfunctional tax and spend policy under the leadership of Mario Monti, but it has hardly moved the needle as the nation drowns in $2 trillion in debt. Both nations would need the equivalent of a huge economic boom in order to raise enough revenue to cover their debts. Unfortunately, that isn’t going to happen for either country given their double-digit unemployment numbers.
Wall Street hopes the ECB will come in and support the Spanish and Italian debt markets indefinitely. Theoretically, the ECB could do it as it can essentially print as many euros as it likes, transferring that debt onto its balance sheet. But at what point do they stop and let the markets take over? There is talk that the ECB will set a cap on bond yields, not just for Spain and Italy, but for all eurozone members, which would ensure that the member states can issue debt to the public at rates they can afford. To facilitate such a mechanism, it would simply buy up enough debt to push yields down.
This is the sort of plan that will either live or die on the details, which should be revealed to the market in September. If done right, it could be a backdoor way for the ECB to introduce eurobonds to the market. By assuming a large sampling of eurozone debt on its balance sheet, the ECB can essentially turn around and use the pool of debt to issue a security that can be sold to investors. Eventually, the ECB would drop the ruse and just assume all the continent’s debt and the eurobond would be born. If the plan works, it would be the first concrete step needed to put an end to the crisis once and for all.
But provided that this quixotic backdoor-debt-mutualization scheme is even an option, the ECB still wants it to be the last option. Draghi wants member states to go to the bailout funds for help first before coming to his office in Frankfurt. So how are the funds doing? Well, the EFSF, in conjunction with the IMF, first bailed out the little guys – Ireland, Portugal and Greece – costing the fund 192 billion euros so far. Greece may need another 14 billion euros next month, so that bumps the total up to 206 billion euros. The fund also has committed 100 billion euros to prop up Spain’s property-bubble-ravaged banks. That leaves the fund with just 134 billion euros. That is simply not going to cut it as Spain and Italy need an estimated 170 billion euros of financing just to make it the to end of the year – and that precludes a possible multi-billion euro bailout of the Italian banking sector, which is surely in the cards at some point.
Enter the ESM. Its size is in flux but we know that the total lending facility that eurozone members have agreed to for all bailout funds is 700 billion euros. If the EFSF caps out at 500 billion euros, that essentially leaves just 200 billion euros for the ESM. Most likely the 134 billion left in the EFSF would be transferred to the ESM when it is ready to go in October, giving the fund a grand total of 334 billion euros. If all the money is made available at once and not split up as mandated, then around half of the money would be eaten away to finance Italy and Spain for the rest of the year, provided they are not able to sell their debt to private investors at reasonable rates. If Spain and Italy eat the entire 170 billion euros needed, that means the bailout fund would theoretically enter 2013 with just 164 billion euros. Spain and Italy need 327 billion euros next year, which means the bailout fund could be totally exhausted by the middle of 2013.
While short, the bailout fund buys the continent some precious time to come to a more lasting solution to the eurozone crisis. Unfortunately, there is a chance that they won’t get any time at all. That’s because on September 12th the German constitutional court will rule on the legality of Germany’s participation in the ESM. Germany is the largest backer of the fund and its strong credit rating is being used to attract investors. If it is forced to withdraw suddenly, then the entire bailout mechanism would collapse.
While it is true that the bailout funds are essentially a stop-gap measure and not a solution to the crisis, word of its failure could still spark panic in the markets. It is unclear what could happen, but the strain from the shock would certainly test the resolve of eurozone members to stay in the club, especially those that have already voiced their displeasure with bailouts, like Finland. It could also tip the balance in the Dutch elections to parties hostile to the eurozone, leading to its possible withdrawal from the club. And it could also push ECB and IMF officials in Greece to deny the country’s cries for more money, forcing the nation to default on its debt payment due next month, setting off a chain reaction that could finally force the country out of the eurozone.
The ECB could try to head off a panic by reassuring the markets that it would start buying bonds immediately if the bailout fund collapses. In any case, hopefully the eurozone leaders who took off time this month to go to the beach return home well rested, as there appears to be a strong possibility that they aren’t going to get much sleep in September.