The eurozone sovereign debt situation is on a cliff edge. This may sound like a statement of the obvious given the chaos within financial markets, but there is a very real sense in which this analogy holds. If sovereign debt default is limited to Greece, then it may be possible to contain the problem. There will be good ways and bad ways of dealing with the problem of Greek default, but Greece is relatively small compared with the total capacity of European financial markets so catastrophe should be avoided. If Spain, Italy, Ireland and Portugal do not default, we just stay on the land side of the cliff.
On the other hand, a debt default involving Spain and Italy – and possibly even Ireland and Portugal – would be a catastrophe. And this is much more likely to happen if there is further recession. Many journalists and financial market practitioners are just calling for political will to be exercised to resolve the crisis. If only the Germans had the courage, it is argued, we could resolve this problem. This is a delusion.
Already 30 per cent of the European Financial Stability Facility is being guaranteed by the countries that are in trouble. The European Central Bank stands behind the EFSF, but this also has its capital provided by the eurozone countries. This situation is like two people going to the bank and admitting that they are both insolvent, but asking the bank for more money on condition that they will guarantee each other's loans. If the eurozone governments in general recapitalise the banking sector in the event of a major sovereign debt write off, then other countries will run into trouble – France being the most obvious candidate. The whole of Europe will stand on Germany's increasing narrow shoulders.
Read the rest of the article here .