Practical steps to prevent eurozone meltdown

There is a real risk of the US government defaulting on its debts and - for unconnected reasons - also a danger of a whole string of sovereign defaults within the eurozone, which would foist losses on banks and financial institutions on a scale that would make the great crash of 2008 look like a shower on a sunny day.

And yet equity markets aren't in meltdown, the price of US Treasury bonds hasn't cracked and the price of gold (the putatively safe haven) hasn't risen as much as you might have expected.

Which tells you that investors and bankers assume that governments of the old rich West will eventually take evasive action - that President Obama and the Republicans will reach an accommodation on spending cuts that would allow the amount that the state can borrow to be increased, and also that eurozone governments will put enough money where their rhetoric has been on their determination to protect the integrity of the currency union.

But can Germany in particular make the financial commitment that is now perceived necessary to re-establish investors' and bankers' confidence that the eurozone as currently constituted will survive?

Because my conversations with those who run large banks and large funds make it clear that the crisis in the eurozone is no longer about Greece - or rather Greece is only a modest element of what concerns them.

They take it for granted that there will be big losses on loans to the Greek state and private sector - probably at least 200bn euros.

There is no longer a scintilla of doubt in their minds that there will be a restructuring of Greek sovereign loans, a reduction in what the Greek government owes to a level that may be affordable for Greek taxpayers.

It is what follows which concerns them.

The worst case chain reaction from Greek default, whether orderly or disorderly, would probably go like this: a heightened perceived risk of default by the other two bailed-out nations, Ireland and Greece; an increase in expected losses for banks exposed to the financially over-stretched troika of Greece, Ireland and Portugal; a potentially devastating funding or liquidity crisis for banks if providers of wholesale finance decide to shun eurozone banks; a potentially devastating funding or liquidity crisis for Italy and Spain, if lenders decide to shun those economies regarded as next most at risk; default by Italy and/or Spain, sparking losses for banks and a new credit crunch that tips the global economy back into recession or worse.

What went wrong in the eurozone?

These are massive, real dominoes that are wobbling and could fall at any time. But they don't have to tumble: the eurozone has the ability to insert dampeners, buffers and defences so that, as and when Greece defaults, the reverberations are uncomfortable rather than calamitous.

There are four such possible circuit breakers.

We'll know the effectiveness of one of these tomorrow - when the European Banking Authority publishes the results of its investigation of "stress tests" of whether the 90-odd most important European banks have adequate capital and liquidity to withstand possible shocks.

What bankers and investors tell me is most important about the stress-test results is that they should include enough detail about the risks to which individual banks are exposed so that the banks' creditors know the risks they are running.

The cancer for the banking system is the uncertainty about which banks are weakest - because if there's a sense that some banks are at risk of going bust, but it is not clear which, the rational response of any creditor is to shun them all.

Which takes me to circuit breaker number two: eurozone governments would have to make a statement, over the coming weekend, that they would provide whatever capital is required by those banks that fail the stress tests or are close to failing the stress tests and are unable to raise such capital from private investors.

It beggars belief that we won't get such a statement from eurozone governments - but you never know.

Next, and this circuit breaker is proving elusive, the eurozone probably has to provide a collective guarantee to absorb some of the losses generated by countries like Greece - and also possibly Ireland and Portugal - that have borrowed more than they can afford to repay.

It is probably encouraging that there is growing talk among European regulators and ministers that the eurozone's bailout fund, the European Financial Stability Facility, should be able to buy Greek bonds in the market and then only demand repayment from Greece of the price actually paid for those bonds, the amount actually invested in the bonds.

In theory this policy of buying and cancelling some of the debt would reduce Greece's indebtedness, because the market price of its bonds is a fraction of the amount originally borrowed: if the EFSF paid 50m euros for Greek bonds with a face value of 100m euros, and agreed that Greece should have an obligation to replay only the 50m euros, that would reduce Greece's indebtedness by 50m euros.

But although deploying the EFSF in that way would help to put Greek public finances and the Greek economy back on the path to recovery, on its own it might actually exacerbate the crisis of confidence in the eurozone, if seen as a precedent for write-offs by other sovereign borrowers.

So the final circuit breaker - and the one seen increasingly as the most important, but is far and away the hardest to put in place - would be for eurozone governments to collectively agree to increase the resources of the EFSF to a size where it would be perceived to be big enough to lend to economies as big as Italy or Spain, in the event that private-sector lenders were to go on strike.

The problem is that the EFSF would probably need authority to borrow something like 2tn euros, or more than four times the EFSF's current size - according to Royal Bank of Scotland, for example - for it to be seen as a credible lender of last resort to eurozone members deprived of access to finance from conventional sources.

And the biggest chunk of that 2tn euros would in effect be lending by German taxpayers, which would be highly controversial in Germany, where there appears considerable popular resistance to the idea that they should increase their exposure to the rest of the eurozone.

There is an alternative that would fudge the issue of the extent to which Germany was supporting the rest of the eurozone.

This would be for the European Central Bank, in an explicit policy decision, to start buying distressed eurozone sovereign debt in a much more aggressive way. That is what the US investment bank Morgan Stanley is recommending.

But ECB conversion of Italian debt into euros would be a German subsidy for Italy by the backdoor rather than the front door - in that it would be predicated on the idea that Germany (and other eurozone countries) would be prepared to inject more capital into the ECB in the event that the central bank incurs substantial losses on its lending to overstretched states.

Or to put it another way, there may be no long-term survival for the eurozone unless Germany is prepared to use its balance sheet to underwrite the whole project. German voters, German taxpayers would need to be comfortable about providing backstop, guaranteed finance for the public sectors of any eurozone state that ran into difficulties.

Do the Germans feel a strong enough sense of solidarity with European neighbours to hand over to those neighbours what some will see as blank cheque?

Would they do so, even if new, more stringent eurozone-wide constraints were put in place limiting how much governments can spend relative to what they receive in tax revenues?

The nature of mainstream political and media discourse in Germany right now is not redolent of a nation ready to make that degree of financial commitment in the interests of eurozone cohesion. Which means that those investors who fear the worst may not be alarmist.