Doomsday scenario as euro casualties keep struggling

An Irish radio show played the "new Irish national anthem" to the tune of the German anthem. In Greece, the severe cutbacks in government spending have resulted in strikes and violent protests on the streets of Athens.

In many countries, governments, often unstable coalitions, are struggling to pass legislation, implementing necessary spending cuts or tax increases. In Germany, the paymaster and strength behind the EU, Europe's biggest tabloid Bild asked: "First the Greeks, then the Irish, then will we end up having to pay for everyone in Europe?"

In December, a special EU meeting, convened to discuss the situation, provided a clear pointer to how events might evolve.

The German view, set out by Chancellor Angela Merkel, prevailed. A key element was the requirement for "collective action clauses", effectively forcing lenders to bear losses.

The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur.

New bailout funds would automatically take precedence over existing debt and have to be paid back first. It is clear that the stronger members of the EU, led by Germany, have decided to limit future liability in bailouts.

Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral European sovereigns may be unavoidable. The safety nets introduced for Greece and Ireland are now seen as unlikely to be big enough to rescue larger countries, like Spain and Italy, if they require support. Investors will need to take losses.

This month, Portugal and Spain have managed to issue debt successfully, giving investors confidence, temporarily, that the problems are manageable. However, in Portugal's case, the debt carried a yield of 6.7%. Portugal's 10-year bonds briefly reached 7% this month, a level investors demanded from Greece and Ireland shortly before both countries finally capitulated and accepted bailout packages.

This week's issues will do little to alleviate longer-term pressure. Large volumes of maturing debt mean the test is likely to come sooner rather than later.

European problems now threaten global recovery. China, which contributed around 80% of total global growth in 2010, has expressed growing concern about the problems in Europe.

The doomsday scenario is a breakdown in the euro, such as the withdrawal of defaulting countries or a change in the mechanism. This would lead to a sharp fall in the new currencies, resulting in large losses to holders of debt of those countries. In turn, this would compound existing global imbalances and trigger further American action to weaken the US dollar.

Further rounds of quantitative easing are possible, setting off inflation and destabilising, large-scale capital flows into emerging markets. The result would probably be full-scale currency and trade wars.

Germany, which has been growing strongly, has more than most to fear. A return to the Deutschmark or, more realistically, a euro without the peripheral countries may result in a sharp appreciation of the currency, reducing German export competitiveness.

Events since the announcement of the bailout package in early 2010 are reminiscent of 2008. Then, optimism following bailouts of Bear Stearns and other troubled American banks proved premature. China's recent promise to buy Portuguese bonds is similar to the ill-fated investments of Asian and Middle East sovereign wealth funds in US and European banks.

Eventually with each rescue and the re-emergence of problems, the capacity and will for further support diminished. The EU rescue of Greece and Ireland is reminiscent of US bids to save its banking system, with more and more money being thrown at it.

Two years after the Wall Street Crash, the failure of Austria's Credit-Anstalt in May 1931 was a pivotal event in the ensuing Great Depression. The failure set off a chain reaction in Europe's banking system. Eighty years later, European sovereigns may be about to set off a similar sequence of events with unknown consequences. As Mark Twain observed, history may not repeat, but it does rhyme.

Satyajit Das is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives