The authorities are making at least two mistakes.
One is that they are determined to avoid defaults or haircuts on currently outstanding sovereign debt for fear of provoking a banking crisis. The bondholders of insolvent banks are being protected at the expense of taxpayers.
This is politically unacceptable. A new Irish government to be elected next spring is bound to repudiate the current arrangements. Markets recognise this and that is why the Irish rescue brought no relief.
Second, high interest rates charged on rescue packages make it impossible for the weaker countries to improve their competitiveness vis-à-vis the stronger ones. Divergences will continue to widen and weaker countries will continue to weaken. Mutual resentment between creditors and debtors is liable to grow and there is a real danger that the euro may destroy the political and social cohesion of the EU.
Both mistakes can be corrected. With regard to the first, emergency funds ought to be used to recapitalise banking systems as well as to provide loans to sovereign states. The former would be a more efficient use of funds than the latter. It would leave countries with smaller deficits, and they could regain access to the market sooner if the banking system were properly capitalised.
It is better to inject equity now rather than later and it is better to do it on a Europe-wide basis than each country acting on its own. That would create a European regulatory regime. Europe-wide regulation of banks interferes with national sovereignty less than European control over fiscal policy. And European control over banks is less amenable to political abuse than national control.
The necessary step is to release each bank's current asset level data, both investment and lending portfolios, so that credit and equity market analysts can determine independently how solvent or insolvent each bank is. Knowing what the market expects, the financial authorities can then move forward to recapitalize the banks or have the banks raise money in the capital markets.
[This idea was first discussed in Asset Level Data: The Firewall to Stop European Contagion and Bailouts, where it was noted that there is not enough capital to recapitalize the European banking system for worse case loss assumptions. Therefore, the asset level data must be made available so that credit and equity market analysts can independently verify that worse case loss assumptions are too extreme.]