The people buying bonds issued by Italy and Spain are clearly looking past the dysfunctional balance sheets and focusing on Germany's reluctance to let a major PIIGS country default. So an Italian bond, in the mind of the market, becomes a German bond.

But this sword cuts both ways. If European debts are tossed into one big communal pot with everyone responsible for everyone else, then buying a German bond is the same thing as buying an Italian bond -- since German taxpayers are ultimately on the hook for both. Viewed that way, lending money to Germany for ten years at 2% is hardly risk-free.

Which is why the failure of Germany's most recent bond auction is so interesting:

German Bonds Fall Prey to Contagion

Nov. 26 (Bloomberg) -- European bonds slumped after Germany failed to draw bids for 35 percent of the offered amount at an auction of 10-year bunds, stoking concern the region's debt crisis is infecting even the safest sovereign securities.

Thirty-year German bonds slid, with yields rising the most since the week through Sept. 3, 2010, amid concern Germany will need to offer greater financial support to its euro-area peers. "Non-residential investors are increasingly troubled by events," said Eric Wand, a fixed-income strategist at Lloyds Bank Corporate Markets in London. "It was ignited by the 10- year bund auction result showing further credit dilution, and hasn't been helped by the outcome of Italian sales."

Thirty-year German bond yields rose 21 basis points to 2.83 percent at 4:54 p.m. London time yesterday, from 2.61 percent the week earlier.

Total bids at the auction of German securities due in January 2022 amounted to 3.889 billion euros ($5.15 billion), out of a maximum target for the sale of 6 billion euros, sparking concern that the turmoil emanating from Greece's debt crisis now risks engulfing the region's biggest economy.

And last week was just the warmup for next week's deluge of new borrowing:

Italy Leads Busy Week of Euro-Zone Bond Sales

FRANKFURT--Italy, Belgium, Spain and France all plan to sell bonds next week, a big test for a region still reeling from unexpectedly weak demand for debt from its German core.

Given the surge in bond-market yields in recent weeks, all four countries are expected to pay considerably more for cash than they did at their previous auctions. Just how much higher the tab turns out to be will indicate the extent to which investors are giving up on the ability of politicians to take tough measures to reduce their debt loads.

All told, five euro-zone governments are together expected to sell about €19 billion ($25.36 billion) in debt next week, more than double the amount three governments sold this week.

Italy will offer up to €750 million in 2023-dated inflation-linked bonds on Monday, followed a day later by up to €8 billion in debt maturing in 2014, 2020 and 2022. The sales come after the country on Friday paid 6.5% to borrow six-month funds, nearly double the 3.5% it paid only a month ago, and its bond yields again soared, to worrying levels solidly above 7%.

Meanwhile, the shape of the bailout is becoming more clear:

IMF Readying Loan of as Much as $794 Billion for Italy, La Stampa Reports

The International Monetary Fund is preparing a 600-billion euro ($794 billion) loan for Italy in case the country's debt crisis worsens, La Stampa said.

The money would give Italy's Prime Minister Mario Monti 12 to 18 months to implement his reforms without having to refinance the country's existing debt, the Italian daily reported, without saying where it got the information. Monti could draw on the money if his planned austerity measures fail to stop speculation on Italian debt, La Stampa said.

Italy would pay an interest rate of 4 percent to 5 percent on the loan, the newspaper said. The amount could vary from 400 billion euros to 600 billion euros, La Stampa said.

Huge week coming up

It's no surprise that a new bailout is announced today. Without a compelling distraction, the markets would fixate on upcoming bond sales and would probably demand even higher rates, effectively bankrupting the PIIGS countries and hobbling Germany and France. So something big has to happen, and right away.

The International Monetary Fund, meanwhile, isn't some independent government with farms and factories and oil wells that it can tax to fund its foreign aid activities. It's just a bank, sort of, holding deposits from the US and other formerly rich countries, which it then lends to supposedly poorer ones. So an IMF loan to Italy is in reality a US/German bailout. There is no free lunch, there is no extra money sitting around. Everything the IMF has comes, directly or indirectly, from the printing presses of safe haven governments.

And the soon-to-be-announced 600 billion euro bailout is just for Italy. Since Spain, Ireland and Portugal between them owe just as much and are just as functionally bankrupt, expect them to get as much or more in coming weeks.

Which brings us to the nature and function of money. This game is only possible while the US and Germany have currencies with relatively stable values. Should the dollar and/or euro start to fall, then loan guarantees denominated in those currencies become a lot less attractive. Bond prices will fall commensurately, and the owners of those bonds will have massive losses that they'll have to acknowledge one way or another. The result: zombie banks that can't afford to lend and underfunded pensions that can't meet their obligations -- and the need for even bigger bailouts.

That's why this week is so huge. If investors realize that German bonds are really Italian bonds, they'll demand higher interest rates from all involved (and we should be short the major stock indexes). And if investors realize that the IMF is just the Fed/ECB in drag, they might finally lose faith in those banks' currencies (in which case gold and silver will soar). In either case, it's game over for the current system.