Austerity and labor market reforms are not doing enough to revive the economies of Europe's Mediterranean states. And that is undermining efforts to save national government finances. Ultimately, to remain in the Eurozone, these governments will require massive fiscal transfers, or may be impelled to default on at least half their debt.

After the introduction of the euro in 1999, Italy and Portugal managed moderate growth, and Spain and Greece enjoyed stronger progress; however, labor productivity continued to lag northern European economies, owing to both government policies and geography.

Labor laws made it difficult for firms to reduce their workforces during periods of weak demand and, to exploit new technologies. Consider Fiat—in 2009, its five largest Italian assembly plants produced 650,000 cars with 22,000 workers, while its Tychy Poland plant produced 600,000 vehicles with only 6,100 workers.

Excepting northern Italy, these economies are hardly hotbeds of innovation. That permitted Germany and others to build technology sectors, and create advanced products and services that instigate leaps in value-added per worker.

The Mediterranean region relied too much on tourism, banking, shipping and cheap hands for assembly work, which increasingly moved to Eastern European destinations benefiting from more flexible labor practices and national currencies that adjust real wages to international competitive conditions.

Prior to the euro, market forces would have driven down Mediterranean national currencies vis-à-vis the dollar and German mark, lowering real wages and sustaining employment.

Instead, chronic trade deficits resulted, and Mediterranean governments shored up employment through wasteful spending, and removed older workers from the labor market through early retirement ages and generous pensions. They borrowed, not merely from their citizens and banks, but also sold bonds elsewhere in Europe and North America.

In Spain, real estate investment—from northern Europeans attracted to its warm climate—and the resulting inflow of cash to banks supplemented government foreign borrowing.

When the U.S. real estate crisis caused a global recession and halted recovery, investors saw that sovereign debt was increasing more rapidly than national GDP, and interest rates on sovereign debt rose to unaffordable levels. Portugal and Greece required bailouts—loans from stronger European governments. Banks across the region—saddled with bad business loans—required aid their governments cannot afford, without external assistance.

Austerity and labor market reforms are essential to curb government spending and raise productivity, but in the near term, lays offs, public and private, are driving up unemployment and causing real GDP to stagnate or decline. Consequently, government spending continues to outpace taxes, pushing up debt to GDP ratios.

Recently, promised aid to Mediterranean banks through loans or equity purchases from the European Stability Mechanism may temporarily ease pressures on governments. However, ESM funds at €500 billion may prove inadequate to cover the funding needs of both troubled governments and banks; and the ultimate liability of governments, if banks can’t repay loans and equity injection, despite recent announcements, remains vague.

Investors recognize this.

Despite repeated EU efforts to stabilize the situation, 10-year Italian, Spanish and Portuguese government bonds are yielding nearly 6, 7 and 10 percent respectively—those rates exceed nominal GDP growth, making government finances absolutely unworkable. And then there's  which can’t access capital markets at all.

The combined debt of all four governments is about €3 trillion, and shaky bank liabilities add at least another €1 trillion to sovereign exposure. Half this total would have to be forgiven for government finances to make sense.

So what now? Either Germany and the other rich nations will have to write checks for €2 trillion—not loans but grants—or a similar forced restructuring will be required.

Even if such debt forgiveness could be achieved without instigating panic, the Mediterranean economies would have to endure many years of unemployment well above 10 or even 20 percent to effect “internal devaluation”—wage reductions large enough to attract industry, balance imports with exports, and end reliance on large government deficits to maintain employment.

Also, that would require voters and governments in Germany and other northern states to be sanguine about factories and jobs migrating south—that is no more probable than a €2 trillion grant from Germany and other northern states.

To say Club Med bonds are good only for wallpaper may be a slander on good wall covering.