By Mauro F. Guillen & Emilio Ontiveros

The crisis did not originate in Europe, but it is proving most severe and intractable there. In terms of the real economy, Europe is registering the worst declines in output, highest unemployment, and highest rates of company bankruptcies.

In the financial sector, the convulsions in the market for European government debt are without precedent among developed countries, and the fragility of the banking system is worrisome.

Neutralizing the financial problems is crucial to the economic recovery. The stability of the eurozone is also at stake. The very viability of the common currency is now in question.

Banks in Europe are under pressure not just because of their exposure to bad loans to construction firms, real-estate developers and households. All banks in Europe continue to suffer, in spite of the help that both governments and the European Central Bank have made available to them since the beginning of the crisis. Italian and Spanish banks are among the worst hit, although the government has not yet had to rescue any of the biggest ones.

The situation in these countries is especially delicate because banks are the biggest intermediaries in the financial system. Unlike in the U.S. or the U.K., banks are the most important source of funds for companies, given the relative underdevelopment of the markets for corporate equity and debt.

It is not surprising that Italian and Spanish banks have taken advantage of the European Central Bank’s funding lines to a much greater extent than other eurozone banks.

This effort to shore up their balance sheets has amounted to not much more than a “placebo effect” because of the devastating combination of financial problems and slow growth in the economy.

It is important to keep in mind that a significant share of the funds obtained by European banks from Frankfurt has been used to purchase government bonds.

Nobody expects moving forward the European Central Bank to offer such attractive funds to the banks in terms of the magnitude and the nature of the collateral. As a result, both the market for public debt and the market for bank equities are in for a slide.

Therefore, the trend is for a national compartmentalization of the market for government debt in Europe as more of it is held by banks of the same country, just the opposite of what many economists and analysts think would be necessary to save the euro.

This represents a most paradoxical situation in that the way in which the European Central Bank has intervened is having the effect of undermining the long-term viability of the common currency.

The perverse relationship between banks’ balance sheets and the market for public debt in Europe creates a conundrum for the credit rating agencies.

They are concerned not only about the vicious cycle resulting from the increasingly domestic character of bond-holding within the currency union, but also about the lack of economic growth and the return to recession of several economies.

After nearly four years of crisis, it seems reasonable to predict that debt obligations won’t be met without economic growth.

The IMF has noted that further deleveraging might lead to a deepening of the recession. Banks’ core capital ratios will continue to deteriorate due to higher rates of non-performing loans, and we still have not figured out how to jump start wholesale financing for banks.

If bank recapitalization is necessary to generate confidence and to help credit flow to the real economy, someone must provide the funds.

Right now, with banks priced at 40 percent of their book value on average, the only source of fresh funds is the government, which takes us back to the problems in the market for public debt.

The way out of the crisis seems to be either a concerted action by the surplus governments or help from outside the eurozone.

Mauro F. Guillen is Director of the Lauder Institute at the Wharton School. Emilio Ontiveros is President of AFI and a Professor at Universidad Autonoma de Madrid.