It is premature to be writing post mortems of the Eurozone. However, the unfolding succession of events is proof that whatever Europe has been doing for the last 18 months or so did not work. Satyajit Das reminds us that the wrong diagnosis leads to the wrong treatment. Given that the treatment is manifestly wrong, the field is wide open for an improved diagnosis:

Central to the European debt problems is the credit boom that took place following the introduction of the Euro.

Prior to monetary union in 1999, interest rates charged on loans to individual countries better reflected risk of loss – from currency movements and ability to repay debt. The introduction of the Euro eliminated currency risk. Surprisingly, credit spreads fell sharply, reflecting a lack of differentiation between the credit quality of individual nations.

The mis-pricing of risk was driven by a belief that the entire Euro-zone was AAA rated because of the “implicit” support of Germany. An additional factor was the fact under Basel 1 and to a lesser extent under Basel 2 banking regulations, lending to sovereign nations attracted favourable capital treatment. The combination of these factors drove lending to the peripheral countries and their banks fuelling large credit booms which are now unwinding.

Recklessly violating the rule “what cannot be paid back, won’t be paid back”, the Eurozone elites went all-in to try to rescue banks and their creditors from the effects of the reckless lending to the periphery. Sensing the inevitable death spiral, the bond markets started shunning Eurozone periphery debt, leading to a ballooning headline number for a bailout of all involved:

In reality, an EU support mechanism of something in the order of Euro 1.5-2.0 trillion would be needed to ensure a credible ability to bailout the embattled economies. Some European Finance Ministers have already called for an increase in the ESM to Euro 1.5 trillion. The political support for and economic viability of a facility of this size is unlikely.

At the same time, the terms of the ESM, especially the subordination of existing lenders to bailout funding and the mandatory CAC’s (collective action clauses) will increasingly force lenders and investors to avoid funding vulnerable countries. In effect, this will ensure that the peripheral economies becoming increasingly dependent on EU support, triggering the negative spiral described.

Bond markets, under the influence of this negative spiral, fled from Greek debt. The recent market prices for Greek bonds and Greek credit default swaps imply that market participants with skin in the game are anticipating a default.

In the end, default or restructuring will become inevitable. Initially, minor changes, such as lowering coupons and extending maturities, perhaps as part of debt swaps, will be sought to manage the problem. Ultimately, a major restructuring, involving a significant write off of outstanding debt is likely. This is the case for Greece and perhaps the other peripheral countries.

A major restructuring of sovereign debt would almost certainly trigger a major restructuring for the European banking system also, as, in an echo of 2007, Funding Stresses Hit European Banks.