A group of almost 100 prominent Europeans delivered an open letter to the leaders of all 17 eurozone countries on Wednesday. The letter said, in so many words, what the leaders of Europe now appear to have understood: they cannot go on “kicking the can down the road”. The road has been blocked by the German constitutional court which has found the law establishing the European financial stability fund constitutional, but declared that no further transfers are allowed without Bundestag authorisation. The leaders have also understood that it is not enough to ensure that governments can finance their debt at reasonable interest rates, they must also do something about the banking system.

Faced with the prospect of having to raise additional capital at a time when their shares are selling at a fraction of their book value, the eurozone’s banks have a powerful incentive to reduce their balance sheets by withdrawing credit lines and shrinking their loan portfolios. The banking and sovereign debt problems are mutually self reinforcing. The decline in government bond prices has exposed the banks’ undercapitalisation and the prospect that governments will have to finance recapitalisation has driven up risk premiums on government bonds.

The financial markets are now anxiously waiting for the leaders’ next move. Greece clearly needs an orderly restructuring because a disorderly default could cause a meltdown. The next move will have fateful consequences. It will either calm the markets or drive them to new extremes.