The latest item in the ongoing European crisis is the news that Spain has been promised loans from the EU in order to bail out its banking system. The promise to bail out Spain may provide a burst of positive market sentiment, though I suspect there are some wrinkles ahead before any of that funding will actually be forthcoming. It's a little depressing to reflect on the fact that Spain is one of the four largest European nations, so it's effectively being called on to lend to itself. Somehow, this is seen as Europe "doing the right thing." But what is really happening is that a continent that is already excessively in debt is promising funds so that Spain can increase its government debt, and then needlessly protect the bondholders of Spanish banks, who should be subject to orderly restructuring instead. This is interesting because the new debt will be senior to existing Spanish bonds, much to the chagrin of existing Spanish bondholders, and the bailouts will put the claims of Spanish bank bondholders ahead of the claims of the Spanish citizens who are funding the "recapitalizations." The only way Spain could make a more explicit gift to bank bondholders would be to include wrapping paper and a bow.

Eoin Treacy's view The founding theme of the European community was that no one country should have pre-eminence over another. What might once have been an aspiration has since been dismissed; as the realpolitik of this crisis overtakes ideology. Creditors feel that the administrations and regulatory framework of debtor countries caused the current crisis by failing to use the cheaper cost of credit associated with Euro membership for wise investment. Many debtor nations feel creditors are at least as much to blame for not performing necessary due diligence before making the loans in the first place and for refusing to accept write-downs on bad debts subsequently.

As individual countries are forced to take responsibility for the profligate activities of their respective banking sectors and those of creditor nations, the divergence in the performance of various sovereign bond markets is exacerbated. Spain is the most recent country to be forced to take on the bad debts of its banks and unsurprisingly its bond yields are breaking upwards. At 540 basis points over Bunds, Spanish spreads are now well above even pre-convergence levels. The pressure this is putting on the sovereign greatly increases the possibility that an additional bailout or preferably some form of burden sharing will be required.

Italy has one of the narrowest budget deficits in the Eurozone but by far the highest debt to GDP ratio. I created this chart dating from the 1860s through to 2010 using data from Ken Rogoff and Carmen Reinhart's website. It depicts how Italy's debt mountain was accumulated from the 1970s through to 1990 and has been comparatively stable between 100 and 120% since 1990. In the intervening time Italy gave up the flexibility of the Lira for Germany's low cost of capital. Due to the size of the public debt Italy cannot afford to be locked out of the debt markets. Italian 10-year spreads over Bunds are pushing back up towards 500 basis points.

If we return to the playbook from the Greek, Irish and Portuguese bailouts, government bonds spreads were not contained until the ECB became an active buyer of their respective debt. The LTRO program was initiated following the last surge in Italian spreads. If the developing crises in Spanish and Italian debt are to be contained then some form of external support will be required to act as a catalyst. In the meantime, the benefit of the doubt will need to be given to further deterioration of Spanish and Italian debt.