The wheels have come off the deal agreed by the previous government with the IMF, the EU Commission and the European Central Bank last November. Not because the deal was unfair or because the budgetary tightening cannot be delivered, but because the financial markets have concluded, correctly in my view, that the Irish banks cannot be restructured within the financial parameters of the deal.

The timescale laid out has already been abandoned. The sums do not add up and the laws of arithmetic do not relent in response to the passage of time.

Irish 10-year government bonds ended the week offering a yield of about 9.7 per cent. German government bonds of the same maturity offer only 3.2 per cent. It is generally assumed that the risk of non-payment with the German bonds is zero. If you believe that there is no risk of non-payment with the Irish bonds, they are a fantastic bargain. With no risk they should yield no more than the German ones and their price is far too low. I will spare you the mathematics, but their price should be at least 150 per cent of the price actually available on the market. The reason investors are not rushing to buy is that they expect default, which means failure to pay some or all of the interest and principal due.

Actually, sovereign bonds never default fully. In a worst-case scenario they might still pay 60 per cent or 70 per cent of the face value, so it is not possible to talk about a unique probability of default. It depends on what haircut is assumed. For the moment, let it stand that a serious risk of default is built into the free market price of these bonds, which are traded every weekday in a liquid market. Any stockbroker will buy you some if you fancy the risk.

Ten years is a long time and default, or better just partial default, after seven or eight years of juicy returns, would not be too bad. But the picture unfortunately is the same for five-year bonds. The Irish five-year bond is trading at the same big discount to its German counterpart, as does the 10-year version. So whatever the markets fear, they think it will happen sooner rather than later.

The picture in Greece is even worse. The market prices of Greek bonds suggest that the default risk is perceived to be even higher and more immediate than is the case for Ireland. If you disagree with the market, your stockbroker can buy some Greek government bonds for you, denominated in euros and maturing as soon as May 2014, which yield over 18 per cent. Both Greece and Ireland have had to withdraw from bond markets and can borrow only from the IMF/EU programmes. Portugal is heading in the same direction. Yields on Portuguese bonds have risen further during the week and have now reached levels which also imply high perceived probabilities of default.

The prospect of several Eurozone countries defaulting on sovereign debt has not been publicly accepted by the EU Commission and the European Central Bank. They appear to believe that these countries can avoid default through domestic actions alone, in particular through tighter budgetary policy.

Most economists agree that tighter budgetary policy, consisting of tax increases and expenditure cuts, is necessary but do not believe that this will be enough. The markets agree with the economists and not with the EU Commission and the ECB. So it follows that the European authorities are proceeding on the basis that the markets are wrong and that there is no risk of default. It is more or less an open secret that the IMF agrees with the economists and the markets, and does not agree with the EU Commission and the ECB.

If fiscal stringency, however inevitable, will not resolve the immediate crisis in the European periphery, it is necessary to consider measures, in the short-term, which will reduce the risk of disorderly default. That means decisions about the distribution of losses on sovereign and bank debt, losses that have, according to the markets, already occurred. It is the European authorities, and not everyone else, that are out of step in believing that kick-and-hope is an adequate policy response.

In the Financial Times during the week, their respected columnist Martin Wolf expressed a view not just critical of European policy but also representative of mainstream opinion amongst economic and financial commentators.

He wrote: "I find it hard to believe that debt restructuring will be avoided everywhere. I find it unforgivable that the last Irish government guaranteed bank debt so insouciantly and that the rest of the European Union has supported this decision. For a sovereign to destroy its own credit, to save creditors of its banks, is plainly wrong. It does not make it better, but worse, that it is doing so largely to protect financial systems in other countries."

The oft-expressed view of European decision-makers, that the troubled periphery countries can bail themselves out through fiscal stringency alone, has virtually no supporters amongst economic and financial commentators, whose virtual unanimity on the issue is itself an unusual state of affairs.

Last Monday evening in a lecture at the London School of Economics, former Taoiseach John Bruton drew attention to the fact, and a fact it is, that the beneficiaries of the Irish bank guarantee are not bankers or developers. They are the creditors of the Irish banks, including imprudent European lenders to those banks. Understandably this is seen as unfair in Ireland. But the most effective case for a review of the IMF/EU deal of November 28 last, which sought to copper-fasten the rescue of Irish and European bondholders with Irish taxpayers' money, is not its lack of fairness, it is its impracticality. It is now clear that the restructuring of the Irish banks as envisaged in the November deal cannot be implemented.

The resolution of the three-year-old banking crisis is one of the critical economic policy tasks facing the new Government. There can be no sustainable economic recovery, and hence no sustainable job creation, until credit and confidence are restored in the private sector of the economy. This requires a functioning banking system, credit readily available to viable businesses and real movement towards a balanced budget.

During the prolonged 1980s public finance crisis, business confidence was not restored until the budget deficit had been decisively addressed. And of course it needs cost competitiveness.

Businesses which export or which must compete with imports cannot prosper under the handicap of excess costs in Ireland.

The Programme for Government acknowledges the urgency of resolving the banking crisis, but it is now clear that the plan outlined in the IMF/EU deal to deleverage and then recapitalise the banks cannot be financed within the resources available. Nor can the finances available be magically enhanced by delay in implementation.

The sale of bank loan assets, whenever it is undertaken, will involve greater write-offs than have been provided for. The programme defers action until the results of the bank stress tests are known, perhaps early in April, at which point the resources available will be precisely as inadequate as they are now.

There are two tasks facing European leaders. The first is the avoidance of disorderly default on sovereign debt in three, or possibly more, eurozone member states. The apparent indifference of EU and ECB officials to this prospect is extremely irresponsible. The second is the resolution of a Europe-wide banking crisis, uneven in its intensity but affecting virtually every EU state to some degree, which would go a long way towards dealing with the default threat.

Practical policymaking requires that the task be identified without wishful thinking, and that the best course of action, however distasteful, be accepted. It is Ireland's misfortune that our European partners have chosen to focus on the political acceptability of solutions rather than the objective nature of the problem.

The new Taoiseach and his ministers, if the press reports are to be believed, have been stressing the impracticality, rather than the unfairness, of the IMF/EU deal for Ireland. That they are right to do so is the mainstream view of the most respected economic and financial commentators across Europe. The new Irish Government should take encouragement from their support.

Colm McCarthy lectures in economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua.

- Colm McCarthy

Originally published in