Leading article: Europe's leaders need to drop their denial

Finance ministers and policymakers urgently need to do more to restore bond market confidence

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The nightmare of full eurozone contagion appears to have moved a step closer. This week investors in European bond markets have become alarmed about Italy. Market interest rates on Italian sovereign debt have spiked upwards. They are now perilously close to the level that sent Greece, Ireland and Portugal over the edge. This is ominous because the €750bn bailout fund, set up last year, is simply not large enough to rescue Italy.

European finance ministers urgently need to do more to restore bond market confidence in Italy which, despite its large debt pile, still looks solvent. Their announcement in Brussels on Monday that the "flexibility and the scope" of the fund will be enhanced is a necessary step. But it is not enough.

The problem is that these policymakers, especially those in France and Germany, seem to be in denial about two crucial dynamics in this crisis. The first is the solvency of private banks across the eurozone. Financial institutions across Europe hold large amounts of sovereign and private debt from eurozone periphery nations. The bond markets estimate that this debt is worth considerably less than these banks are admitting and that some of these institutions are most likely insolvent as a result. That uncertainty is helping to drive the panic on display in financial markets.

The second dynamic is national growth. It is increasingly hard to see how nations on the eurozone periphery, which have uncompetitive economies, can grow their way out of their debt problems while they are locked into the single currency. In the past, these nations would have seen the value of their currencies plummet. This would have increased the costs of imports, but given their export sectors a huge boost. That cannot happen while their trade is conducted in euros.

Both these realities are uncomfortable for European leaders and policymakers. The first means that large numbers of banks probably need to be recapitalised by taxpayers – something that would prompt massive popular anger. The second implies that some nations might need to leave the eurozone if their economies are ever to recover.

European leaders have responded to such suggestions with bluster. They have declared all banks to be solvent and insisted that a programme of public austerity can solve the eurozone's economic problems. As for the break-up of the eurozone, that has been dismissed as a political and economic impossibility.

This week there is a chance for them to adopt a more realistic line. The results of another official round of "stress tests" for European banks are due to be announced on Friday. The last tests, conducted in July 2010, declared Ireland's banks sound. Within months they had collapsed. These new tests need to be credible to calm the markets. And any bank that is insolvent needs to be swiftly recapitalised. Political leaders must swallow the political costs of that.

The growth problem is much more difficult. The eurozone has no exit mechanism. And to attempt to create one would inevitably create massive instability. Yet massive instability is a reality now. One thing is certain: until the official denial about what is driving this crisis ends, there is no end in sight for the eurozone's agony at the hands of the bond markets.

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