There was good news in this summit Europe s leaders have finally understood that the bootstrap operation by which Europe lends money to the banks to save the sovereigns, and to the sovereigns to save the banks, will not work.

Indeed, sovereigns are dumping a larger fraction of their public debt onto banks balance sheet, especially in the eurozone.

As investors reduce their exposure to the eurozone periphery s sovereigns, banks, and corporations, both flow and stock imbalances will need to be financed.

Thus, in addition to an orderly resolution regime for banks, Europe must also implement early orderly restructurings of distressed sovereigns public debt.

First, repair. Before doing anything else, we must relieve some of the balance sheet pressures on sovereigns, households, and banks that risk smothering the recovery.

Obvious, unconventional measures, if not carefully monitored, might have the unintended consequence of creating an abnormally benign financial environment for markets, commercial banks, and sovereigns.

One of the main problems today is too much debt in the global financial system among sovereigns, banks, and households, and especially among the advanced economies.

And, in Europe, the sovereigns must address firmly their financing problems through credible fiscal consolidation. In addition, to support growth, banks must have sufficient capital buffers.

In the eyes of most observers, to reach the leaders goal of break ing the vicious circle between banks and sovereigns required centralizing authority for bank resolution and rescue.

But no one will bail out these super sovereigns if the sovereigns prove to be insolvent.

Similarly, super sovereigns cannot continue to bail out distressed sovereigns that are insolvent rather than illiquid.

In the second stage, starting in the spring of 2009, the crisis spread to the sovereigns, as investors grew increasingly worried that propping up banks would strain government finances. In turn, sovereign weakness made the banks appear riskier, and the banks and their home governments became joined at the hip.

Public debt is already high, and many sovereigns are near distress, so governments ability to backstop their banks via more bailouts, guarantees, and ring fencing of questionable assets is severely constrained.

Meanwhile, the ability to backstop, ring fence, and bail out banks and other financial institutions is constrained by politics and near insolvent sovereigns inability to absorb additional losses from their banking systems.

In the second stage, starting in the spring of 2009, the crisis spread to the sovereigns, as investors grew increasingly worried that propping up banks would strain government finances.

But an immediate corollary of this diagnosis is that dealing with this crisis requires finding a solution to the debt problem that is, the problem of over indebted sovereigns and insolvent banks.

Is not Allah the Greatest of all sovereigns ?

Is not Allah the Greatest of all sovereigns ?

Before doing anything else, we must relieve some of the balance sheet pressures on sovereigns, households, and banks that risk smothering the recovery. Advanced countries need credible medium term plans to stabilize and reduce public debt.

A banking union consisting of common deposit insurance, supervision, and crisis resolution would help to avoid the mutual contamination of banks and sovereigns, which is why the idea was endorsed at the recent G 20 summit in Mexico.

The Germans and French would need to inject new capital into their banks (perhaps finally becoming open to tighter regulation to prevent this from happening again), and the whole world would become more wary about lending to profligate sovereigns.

The second objective should be to break the link between banks and sovereigns, which has been a particularly dangerous feature of the last year, while the third is to minimize the risks for taxpayers through adequate contributions by the financial industry.

And the same is true, albeit to a lesser degree, for other heavily indebted sovereigns.

But an immediate corollary of this diagnosis is that dealing with this crisis requires finding a solution to the debt problem that is, the problem of over indebted sovereigns and insolvent banks. Unfortunately, nothing is being done on either of these crucial fronts.

Indeed, in contrast to the United States, eurozone authorities were slow to consolidate the banking system after the global financial crisis erupted in 2008, and failed to sever the ties between sovereigns and banks balance sheets. Nor did they push strongly for structural reforms.

The resulting private sector imbalances culminated in banking problems that were eventually transferred to sovereigns.

The fewer sovereigns there are, the easier it will be to secure the necessary cooperation.

These states refused to recognise William III, Mary II or Queen Anne as legitimate sovereigns.

But no one will bail out these super sovereigns if the sovereigns prove to be insolvent. Thus, the current strategy of kicking the can down the road will soon reach its limits, and a different plan will be needed to save the eurozone.

Breaking the negative feedback loop between distressed sovereigns and distressed banks whereby bank rescues exhaust fiscal resources and make it likely that the next financial institution in trouble will not be able to count on government support requires ensuring that it will not recur even in extreme circumstances.

After all, sovereigns are called that because they have the power to impose taxes, regulations, and, at the extreme, confiscation.

Without a credible threat to cut off wayward sovereigns, the ECB s pledge provides a free lunch to investors and governments alike.

Fifth, some argued that highly indebted sovereigns would push investors into gold as government bonds became more risky.

Then, distressed sovereigns that had already lost market access Greece and Ireland were bailed out by the International Monetary Fund and the European Union.

Rather than resorting time after time to bailouts and delay, isn t there a way to more swiftly and decisively restructure the debts of insolvent sovereigns?

Variations Depending on the source, there are many variations of who classifies as the Three Sovereigns or the Five Emperors.

(Indeed, by most accounts, it is about to default.) And the same is true, albeit to a lesser degree, for other heavily indebted sovereigns.

When banks stopped providing short term liquidity to other banks and industrial companies, central banks filled the gap.

Borrowing costs are rising for highly indebted sovereigns, credit rationing is undermining small and medium size companies, and falling commodity prices are reducing exporting countries income.

Until recently, the conventional view was that mature sovereigns always honored their debts, while only banana republics failed to do so.

How to Bail out Good Banks and Let Bad Banks Fail

A world in which different sovereigns regulate finance in diverse ways requires traffic rules to manage the intersection of separate national policies.

Of Banks and Bailouts

The reaction among national politicians, central banks, and banks themselves was not universally favorable.

Forcing bondholders to accept a haircut on what they will be paid also promises to discourage reckless lending to eurozone sovereigns in the future.