Lithuanian President Grybauskaite, German Chancellor Merkel and Irish Prime Minister Cowen talk together
Lithuanian President Grybauskaite, German Chancellor Merkel and Irish Prime Minister Cowen talk together Reuters

The capital markets succeeded in strong-arming the European Union (EU) to provide an 85-billion euro bailout package for Ireland and for the Irish government to accept it with the imposition of some harsh austerity measures.

However, the aid package, so far, has not achieved its two main goals. It has failed to restore private investors' appetite for Irish government bonds. Perhaps more importantly, fears of a sovereign debt contagion are spreading to other peripheral euro zone members and even to quasi-core countries like Italy and Belgium, said Joachim Fels and Elga Bartsch, two economists at Morgan Stanley.

What went wrong?

First, even if officials of the EU, the Irish government and the International Monetary Fund (IMF) played all their cards right, the type of bailout they were planning to offer could not, and were not designed to, solve some key issues.

The root of Europe's sovereign debt crisis was an economic system with a centralized monetary authority but de-centralized fiscal authorities. Monetary and fiscal policies must match and this flawed structure makes that impossible.

A related problem -- and a political dilemma -- lies with the competing interests of the bailout receivers and the bailout providers. For example, German taxpayers complain about footing the bill, while Irish citizens protest the draconian austerity measures and spending cuts thrust upon them.

Europe's bailout strategy -- involving core Europe sending money to peripheral Europe, and the latter agreeing to austerity measures -- obviously does not address these fundamental problems.

On top of that, some critics argue that Europe's bailout concept is flawed because it simply piles up more debt (bailout loans) onto countries' whose problem was too much debt in the first place.

However, European policymakers also made mistakes in executing their loan and austerity program, according to Fels and Bartsch.

First, the average annual interest rate for the IMF and EU loans to Ireland was set up at 5.8 percent, which is too high for a country that will struggle to generate much nominal GDP growth over the next several years.

Second, the bailout provided no clarity on other peripheral countries under selling pressure such as Portugal and Spain.

Third -- and most importantly, said the Morgan Stanley economists -- European officials made the mistake of clarifying the permanent bailout mechanism that will take effect after 2013.

Actually, initial talks of this mechanism, which will have the private sector sharing a greater burden of future bailout costs, was responsible for the renewed euro zone sovereign debt fears and triggering the Irish debt crisis in the first place.

The reason is that some investors bought peripheral European debt under the assumption -- and hope -- that all the bailout costs would be shouldered by taxpayers, not themselves.

Regarding these clarifications, European officials said the participation of private investors in future bailouts will be decided on a case-by-case basis, which serve as confirmation that investors sharing in bailout costs is indeed a possibility, said Fels and Bartsch.

In addition, the clarification that bailout loans would be senior to private investors' own loans further spooked the market.

The bonds of several peripheral countries, while still being government bonds in name, no longer offer the advantages of a government bond - safety, liquidity, low volatility and a negative correlation with risky assets, said Fels and Bartsch.

Whether intentional or unintentional, the failure on the part of European officials kicks the responsibility to Jean-Claude Trichet, the head of Europe's monetary authority. Trichet can end this crisis -- but perhaps cause an even bigger one -- if he just purchases massive amounts of peripheral European government debt.

However, Fels and Bartsch think that Trichet will not do that because of the central bankers' belief that the sovereign debt crisis needs to be addressed first and foremost by euro area governments.

Instead, they think Trichet will use the urgency of this crisis to get governments to complete some of unfinished work on euro area governance -- a fiscal federation.

A fiscal federation, unlike the bailouts, would address some of the underlying causes of the peripheral European debt crises.

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