EU Summit: Further Integration Won't Fix Club Med States

NEW YORK (TheStreet) -- European Union leaders are considering radical reforms to restore confidence in the euro and the finances of Mediterranean states. These reforms and relief efforts for troubled governments are doomed to fail, and it would be better for these states to radically restructure sovereign debt now and exit the euro. Continuing the charade that their situations can be saved will only make the pain worse later.

Public debt now exceeds 150% and 120% of GDP in Greece and Italy. Those ratios continue to rise, because austerity is causing their economies and tax bases to shrink. Longer term, accompanying economic reforms may instigate some growth, but not enough to permit Athens and Rome to pay interest and start retiring principal - simply, Greece and Italy are insolvent.

Spain's debt is only about 75% of GDP. However, its banks are heavily burdened by souring real estate loans totaling about 665 billion euros -- more than 60% of Spanish GDP. Banks don't have the capital to cover those losses; however, with their survival essential to national economic recovery, bad real estate loans are an implicit liability of the Spanish government. Altogether, Madrid's implicit sovereign debt is much closer to 100% of GDP and rising rapidly.

Spain, like Italy, must pay more than 6% on new 10-year government bonds -- Greece, currently receiving European bailout financing, is not in the private credit market, but when it returns, it will pay at least what Italy pays. Portugal, whose situation mirrors the others, is paying about 9.5%.

Even in the unlikely event austerity and economic reforms instigate some modest growth in 2013, it would be inadequate.

To keep the debt to GDP ratio from rising, nominal growth (real growth plus inflation) must exceed the interest rate paid on debt plus current government deficits as a percent of GDP. Across the Mediterranean states, the latter sum is likely to be at least 9% for the foreseeable future, and real growth plus inflation are simply not going to be that high.

Only the likelihood that Germany and other northern states will bail out the Club Med states keeps the interest rate on Italian and Spanish bonds from zooming past 10% and instigating sovereign default.

For Mediterranean states' public finances to be manageable, sovereign debt would have to be cut in half through restructuring, and private bondholders and European banks would take large losses.