Time is running out for Europe’s politicians.

They had been hoping that markets would calm down later this month, once the German parliament, the Bundestag, gave its formal blessing to a recent agreement that will boost the size of the eurozone’s emergency bailout fund and provide powers so that it could recapitalise troubled banks. But these hopes have been dashed by the latest burst of market turbulence.

Overnight, German Chancellor Angela Merkel tried to calm markets by dismissing speculation about an imminent Greek debt default. “I think we will do Greece the biggest favour by not speculating much, but instead encouraging Greece to implement the commitments it has made,” she said in a radio interview. “What we don’t need is unrest in the financial markets — the uncertainties are already big enough.”

But financial markets remain extremely fraught. Overnight, Italy had to pay the highest interest rates since joining the euro in 1999 in order to sell five-year bonds. Investors worried that Italian bond yields were continuing to move higher, despite the efforts of the European Central Bank to push yields down by buying Italian bonds in the secondary markets. Meanwhile, Greek two-year bond yields climbed above 85%.

Investors are increasingly questioning whether Europe’s leading politicians can keep the deteriorating situation from spinning out of control. There was confusion overnight after Germany and France scrapped earlier plans to issue a joint statement. According to  French newspaper Le Monde, the Franco-German statement would have emphasised the unwavering support that both governments had for their banks, and their commitment to expanding the powers of the eurozone bailout fund. In the end, it was decided that it would be better not to unsettle markets by mentioning the banks.

Instead, Germany’s Merkel, and French President Nicolas Sarkozy will hold a video conference call with Greek Prime Minister George Papandreou later today. In the call, Merkel and Sarkozy will urge Greece to push ahead with austerity measures to ensure the country receives its next instalment of bailout funding. Greece has said it only has a few weeks’ cash and needs the €8 billion tranche in October to pay salaries and pensions.

Officials from the “troika” — the European Central Bank, the European Commission and the International Monetary Fund — are due back in Athens later today to decide whether Greece has fulfilled the conditions for more aid. Their last visit ended abruptly when the officials formed the view that Greece had not made enough progress. As Commerzbank noted wryly in a note to clients, “it is hardly likely that it will find a hugely different scenario there than was the case one and a half weeks ago”.

Meanwhile, Citigroup’s highly respected chief economist Willem Buiter says that a Greek exit from the eurozone, while still unlikely, has become a lot more possible in the past few weeks.

But, he thunders, a Greek exit “would be a financial and economic disaster not only for Greece, but also for 16 continuing euro area member states, and that it would also have severe economic and political implications for the whole of the EU and the wider global economy”.

Buiter argues there is an extreme risk of contagion throughout the eurozone. As soon as Greece exited, and introduced a new drachma, markets would focus on the country or countries most likely to exit next. Depositors, fearing the introduction of a new escudo, a new punt, a new peseta or a new lira (to name some of the most obvious candidates) would pull out funds from banks in these countries, and deposit them in the handful of countries most likely to remain in the eurozone — such as Germany, Luxembourg, the Netherlands, Austria and Finland.

At the same time, borrowers in countries considered at risk of exiting the eurozone would face “de facto funding strikes by external investors and lenders”.

*This first appeared on Business Spectator.