Mediterranean Debt Losses Could Top 2 Trillion Euros

Austerity and labor market reforms are essential to curb government spending and raise productivity, but in the near term, layoffs, public and private, are driving up unemployment and causing real GDP to stagnate or decline. Consequently, government spending continues to outpace taxes, pushing up debt to GDP ratios.

Recently, promised aid to Mediterranean banks through loans or equity purchases from the European Stability Mechanism may temporarily ease pressures on governments. However, ESM funds at 500 billion euros may prove inadequate to cover the funding needs of both troubled governments and banks; and the ultimate liability of governments, if banks can't repay loans and equity injection, despite recent announcements, remains vague.

Investors recognize this.

Despite repeated EU efforts to stabilize the situation, 10-year Italian, Spanish and Portuguese government bonds are yielding nearly 6%, 7% and 10%, respectively -- those rates exceed nominal GDP growth, making government finances absolutely unworkable. Greece can't access capital markets at all.

The combined debt of all four governments is about 3 trillion euros, and shaky bank liabilities add at least another 1 trillion euros to sovereign exposure. Half this total would have to be forgiven for government finances to make sense.

Either Germany and the other rich nations write checks for 2 trillion euros -- not loans but grants -- or a similar forced restructuring will be required.

Even if such debt forgiveness could be achieved without instigating panic, the Mediterranean economies would have to endure many years of unemployment well above 10% or even 20% to effect "internal devaluation" -- wage reductions large enough to attract industry, balance imports with exports and end reliance on large government deficits to maintain employment.

Also, that would require voters and governments in Germany and other northern states to be sanguine about factories and jobs migrating south -- that is no more probable than a 2 trillion euro grant from Germany and other northern states.

To say Club Med bonds are good only for wallpaper may be a slander on good wall covering.