The European debt crisis drags on and on. It seems to be in the news every day.

Recently, every country in the European Union except Great Britain came to an agreement to draft a treaty among all of those agreeing with tougher budget discipline, automatic sanctions for violators and a small increase in the size of the European Stability Mechanism (ESM). For a day at most, bond (debt) markets seemed satisfied.

Unfortunately, however, that satisfaction was short-lived. We are back to a steady drumbeat of concerns about European sovereign debt, and specifically about the bonds of Italy, Ireland, Portugal and Spain. (Not Greece anymore, as it has been "bailed out.")

Why isn't the planned treaty enough to solve the problem?

Fundamentally, the treaty might well help prevent future problems, but it has no impact on the current debt issue. That is, in the future it might prevent countries from getting in to deeper trouble or into trouble at all, but it provides no tools today to get them out of the trouble they are already in.

What is the problem, then?

There is a fairly broad consensus that the current Eurozone debt situation is largely a crisis of confidence. There is uncertainty among many lenders about the willingness and ability of (especially) Italy, Ireland, Portugal and Spain to pay the interest and principal on their current debt outstanding. This has several effects:

• Banks and other financial institutions are reluctant to hold those bonds – they are afraid if the issuing country defaults, they will lose principal. This causes the price of the debt to fall and the implied interest rate to rise (bond interest rates and bond prices move in opposite directions).
• Then, as the countries in question issue new debt (borrow more money), they must pay higher interest rates. This increases the size of the deficit that they have to cover through lower spending and higher taxes. It is something of a vicious circle.
• Lenders (including depositors) to banks and other financial institutions that do hold the bonds develop doubts about the credit-worthiness of those institutions. (Will the bank be able to pay the depositor if some of the bank's assets decline significantly in value?) At the extreme, lenders may refuse to lend to those institutions – they may demand their money. This would result in a "run" on the bank or institution in question.

What might work?

Confidence must be restored. Lenders must become confident that the bonds in question will not lose value. Two approaches have been proposed:

• A "lender of last resort" could emerge. The US Federal Reserve Bank and the US Treasury played this role in the US credit crisis. You may recall that the US Treasury purchased large quantities of mortgage-backed securities in 2008 and 2009. The Federal Reserve also guaranteed money fund assets, preventing a run on those funds. There are at least two candidates for this role:
• The European Financial Stability Facility (EFSF). This entity has lending capacity of €440 billion. It is to be replaced by the European Stability Mechanism (ESM), with a slightly larger capacity. As Italy's outstanding debt is €1,800 billion, the inadequacy of either of these mechanisms is clear.
• The European Central Bank (ECB) could buy the questionable debt. The ECB is the direct analog of the US Federal Reserve. In theory, its capacity is very large – probably large enough. However, so far, the ECB has declined to buy bonds, indicating that its charter does not permit this.
• The ECB has just made large three-year loans to many European banks on very favorable terms. This provides the participating banks with funds that they can use to (among other purposes) buy bonds from the sovereigns whose credit is in question. It remains to be seen whether this action will be sufficient to restore confidence.
• Alternatively, the Eurozone countries could collectively issue Eurobonds, and purchase the questionable bonds with the proceeds. This would effectively position the entire Eurozone as the borrower, in the place of the individual countries. As I mentioned in my last email, the entire Eurozone does have sufficient capacity to inspire confidence. There has been no move in this direction, however.

Why have the Eurozone countries rejected these solutions so far?

The Eurozone countries whose participation or approval would be essential for any of these solutions – France and Germany are the largest of these – do not want to take financial responsibility for the countries in trouble.

They are concerned that their taxpayers will end up footing the entire bill for any solution. And, while French and German citizens benefit from their participation in the Eurozone, it is unclear how much they are willing to pay to maintain it, and whether they understand what might happen if they don't.

What might happen?

There are more potential scenarios than we have time or space to address, and more than you are likely to have the patience to read about. However, we can consider one at each end of the spectrum.

• Eventually, the leading Eurozone politicians (Merkel of Germany and Sarkozy of France among others) realize that severe financial and economic privation will strike their countries if they don't produce a solution, and they will select one of the approaches I described above. Very much as happens in this country, such a compromise solution is likely to appear only at the very last minute, when hope of a resolution is dwindling. The crisis would then resolve with much noise and gnashing of teeth as the taxpayers complain about what their leaders have committed them to, but it would probably resolve nonetheless.
• At the other end of the spectrum, the politicians may be unable to come to agreement. At the extreme, this could lead to a significant restructuring of the Eurozone, with some countries leaving to issue their own currencies. While the details are hard to predict, it is likely that there would be a severe decline in credit issued by banks in the Eurozone (comparable to what we had here in 2008 and 2009) which could lead to a recession in the Eurozone and subsequently among Eurozone trading partners (including the US).

What should you do?

Significant stock and bond market volatility will continue. Every time a solution appears more likely, stocks ("riskier assets") will rise in price, and bonds ("safer assets") will decline. Every time a solution recedes, the reverse will happen. The market movements that do occur have the potential to be quite sharp, as investor uncertainty is very high.

Unfortunately, no one knows which scenario will eventually occur. There is no way to position your portfolio so that it you can profit no matter what does emerge.

In these circumstances, it is perhaps more important than ever that your portfolio be structured so that you can accomplish your overall financial plan independent of what happens. Please get in touch with me if you would like to review your portfolio's target allocation in that light.