The current fear in policymaking circles in the EU and US is that, if recognised openly and provided for or written down, an immediate recognition of value loss on Eurozone sovereign debt could (and would, from the graph) cause a second banking crisis?this time triggered by the profligacy and irresponsibility of governments rather than bankers. That would result in the Eurozone and the entire EU going into a depression worse than that of the 1930s. It would immediately affect the rest of the world. No country or region would be immune to the fallout of implosion in the world?s largest economic bloc.

At best, Europe would descend into a long period (at least a decade) of stagnation resulting from a high debt, low growth, high tax, low spending trap that would force harsher adjustments in the balance sheets of households, banks and corporates. That might be followed by immediate deflation caused by a widening of the output gap as a result of a sustained slump in economic activity, followed by eventual inflation due to the cumulative effects of prolonged, excessive laxity of both fiscal and monetary policy?? la Japan, which has been locked in the first two of these phases for over 20 years and has yet to enter the third, which it would, if it ever grew sustainably again and let inflation emerge.

As indicated in the graph, extant levels of EU sovereign debt cannot be increased further to finance additional bank capital. That inclination was, in large part, what caused the sovereign debt problem to be exacerbated in the first place, especially in countries with banking systems larger than their economies, i.e. Iceland (which is not a member of the EU), Ireland, the UK, the Netherlands, Belgium and Switzerland, as well as countries like Germany and France. Where the PIIGS are concerned, that was not the primary cause of the sovereign debt problem in Greece or Portugal, but it was to a large extent in Ireland and to a lesser extent in Spain and Italy.

The problem was exacerbated by central banks and regulators requiring European banks not to ?speculate? in securities and derivative markets but instead to build up positions in supposedly ?safe? euro-denominated sovereign bond holdings that regulators thought were liquid, zero-risk in terms of possible future capital loss, and were weighted accordingly in capital requirement risk matrices for banks. Moreover, European regulators treated the risk on Greek bonds as being exactly the same as risk on German bond holdings (i.e. zero) as far as capital requirements for risk-weighted assets were concerned. In retrospect, those regulatory requirements now seem most unwise.

At present, the world is entering a market-impelled phase of fiscal deficit and public debt consolidation, followed by expenditure, deficit and debt reduction (accompanied by tax increases with a demand constraining impact), across the EU and probably around the OECD. The spectre is already being raised (by commentators in the FT, the Labour Party in the UK, neo-Keynesians like Paul Krugman and a flock of Italian economists) that premature withdrawal of stimulus through immediate fiscal tightening and draconian debt/deficit discipline of the kind advocated by the IMF and UK, will tip the world into a W-shaped recession or global depression. That risk exists. All the available indicators in the EU and US suggest that households have not yet adjusted their own consumption-savings-investment balances sufficiently for growth to be reignited and sustained without public intervention. Corporate savings are increasing. But that is mainly because the output gap is growing and corporate (and housing) investment is being withheld until signs of recovery in consumption are firmly established.

What the neo-Keynesians do not accept, however, is that incurring further levels of debt in the EU, Japan and the US to keep stimulating the local and global economy is a path to oblivion. That approach is unsustainable and unfinanceable in global capital markets by dipping into available pools of global savings whether household, corporate or government (in surplus countries). It is an approach that can only be financed through more money-printing, leading to eventual money debasement and a global loss of faith in the store-of-value properties of the three major reserve currencies. When it comes to financing another round of deficits and public debt, stretching over the next 4-8 years until reverse inflexion occurs, markets are unlikely to apply double standards to the EU and the US or Japan despite the temporal ?flight-to-quality? concerns that the market comes up with to rationalise its panic-du-jour.

Yesterday?s flight to quality, when the sub-prime crisis struck, was away from USD-denominated private debt assets towards euro-denominated sovereign bonds. Today?s flight to quality is away from euro-denominated assets to USD, JPY and SFR denominated bonds (and, of course, gold of which there simply is not enough). What will tomorrow?s flight to quality be? At some point realisation must dawn that banks, insurance companies and pension funds in the developed world are simply reshuffling assets (i.e. sovereign paper) of decreasing quality and increasing credit risk, around from one hemisphere to another, day to day, and paying high transaction and risk management costs (for currency, credit quality and interest rate hedges) for achieving little by way of real portfolio value protection in the process?

The simplistic answer would be a structural shift into equities and debt of the key emerging market economies, particularly Brazil, China and India. Collectively, however, these three economies account for less than 12% of world GDP in nominal dollars (but over 22% in PPP terms). So their ability to absorb a massive inflow of diverted global capital or imports is limited. Moreover, such a shift in global investment preference would create other unwanted complications, such as another surge of external capital into these economies resulting in further upward pressure on their exchange rates and further demands for sterilisation that their budgets can ill-afford.

The reality that we refuse, and seem unable, to confront is that all major reserve currencies (USD, EUR, JPY) are shaky, undesirable long-term holds. The structural prospects for these three economies over the next 20-30 years seem distinctly less favourable in relative and absolute terms against those of the larger emerging economies: Brazil, China and India. If one looks at the underlying numbers for major OECD economies (i.e. EU, Japan, US) it is clear that the world (by which is meant the stability of the global financial system) is being put at risk by relying almost exclusively on these three severely compromised and weakened currencies as the only reserves, which underpin that system. These currencies are no longer an effective store-of-value in the coming years though they may remain the most used means-of-exchange.

The quantum of other supposedly strong developed country currencies (SFR, SND, CND, AUD, NKR, etc) is too small for them to ever become credible reserve currencies. If there was ever a case for a global shift of reserve holdings to SDRs it is now, except for the unfortunate fact that the SDR is itself a composite of the three main reserve currencies with small weights of a few others (e.g. GBP). It is becoming clear that the INR, CNY and BRL need to become reserve currencies sooner rather than later. But that is not on the cards, because of the reluctance of China and India to consider removing capital controls, abandoning pure or dirty exchange rate pegs and permitting their currencies to float freely. But, given what is happening to their economies, how long can the EU, US and Japan resist domestic political pressure to insist on using market access, the WTO?s currency manipulation clause, and a countervailing offset import duty, as negotiating chips to oblige India and China to accelerate their playing by global rules for determining the currency values of major trading nations and give them a time bound limit to abide by those rules?

?(To be continued)

The author is an economics and corporate finance expert