The message of these three charts (click on each to enlarge) is that a PIIGS default/restructuring is highly likely to occur, but that it does not pose a serious threat to eurozone banks or the eurozone economy.
The first chart shows the yield on 2-yr sovereign debt for each of the PIIGS countries. The extremely high level of yields on Greek, Irish, and Portuguese bonds is the market's way of saying that a significant default is highly likely to occur.
The second chart shows eurozone swap spreads and U.S. swap spreads. With swap spreads being a good proxy for systemic risk and the default risk of large banks, we can infer that the market assigns a very low level of risk to the U.S. economy and banking system, and a moderate level of risk to the eurozone economy and banking system. Note that the probability of default in PIIGS countries has never been higher than it is today, but euro swap spreads are still lower than they were in April 2010, when the Greek debt problem first surprised the world.
The third chart is Europe's equivalent of our Dow and S&P 500: the Euro Stoxx 50 Index. What it says is that the eurozone economy has been in muddle-through mode ever since the Greek debt crisis broke. Muddle-through, but not collapse by any means.
Friday we received the news that a stress test of European banks found that only 8 would likely fail to survive a worst-case scenario—a significant economic slowdown. Furthermore, these banks had a combined capital shortfall of only $3.5 billion, which is a relative drop in the global capital market bucket. Whether or not you believe this was a serious or rigorous test, it does jibe with the level of swap spreads. Both are saying that yes, there are problems, but these problems are not likely to bring about widespread contagion or financial market collapse. Since the sovereign debt problem has been around for well over a year, it is undoubtedly the case that banks collectively have taken steps to shore up their capital and to reduce their exposure to the sovereigns most likely to default. It is therefore not unreasonable to assume that the market has enforced enough discipline on the system, and enough repricing and restructuring, to render a catastrophe highly unlikely.
As I note before in a post about the consequences of debt defaults, much of the bad news has already been priced in, and it is evident in the fact that the eurozone economy has been growing at a disappointingly slow pace, similar to what the U.S., with its extraordinary deficits, is experiencing. Defaults are symptomatic of debt that has been used to finance wasteful or inefficient spending, and in this case of economies that have used scarce resources ineffectively. Massive, debt-financed government spending cannot stimulate an economy, but it can stifle the ability of the private sector to generate meaningful growth.