The PIIGS are back.

Well, at least the ’P’ is back. Portugal’s stock market has dropped 17% in the last month, thanks to Banco Espirito Santo’s (BES) troubles.

BES is Portugal’s largest bank. Or rather, it was Portugal’s largest bank. Now it’s a penny stock. Investors began playing hot potato with BES stock when auditors discovered “irregularities” on the books of BES’ parent company. Things only got worse from there, culminating with the Portuguese central bank ordering BES to remove and replace its top executives.

Portugal’s problems reminded investors that Europe’s banking problems have not been fixed. The Eurozone still suffers from the same issues that caused its financial crisis. Namely, eighteen countries with diverse economies and divergent priorities are all trying to share one currency. That can’t work, no matter how hard the ECB wishes it will.

Today’s guest contribution comes from Martin Fluck, who’s studied and written about the global financial markets for 20 years. Below, Martin argues that the Eurozone appears to be slowly slipping back toward crisis… and tells us about an event approaching this autumn that could tip Europe’s fragile banks over the edge.

Dan Steinhart

The Stress Tests That Could Stress Markets

If you thought the Eurozone crisis was in the past, think again.

Last week, news that Portuguese bank Banco Espirito Santo was in trouble shook markets. Europe’s financial markets remain jittery, because its banking system is still fragile. Europe’s banks still haven’t repaired their balance sheets, so they’re not willing to lend to each other… never mind lending to small and medium-sized businesses.

The EU is publishing the results of its latest stress tests in October. It hopes the results will restore trust and boost lending to the private sector. But I think the tests might backfire and trigger a fresh crisis.

Should the tests be conducted honestly, they’ll reveal bad loans on overvalued assets. That’s a problem for the Eurozone, because unlike the US, it has no capital in reserve to recapitalize its banks.

The tests are supposed to be as credible as those carried out in the US, but the suspicion is that they have once again been designed to paper over the fact that the entire EU banking system is insolvent. Remember: Belgian Bank Dexia got top marks in Europe’s last round of stress tests in 2011, but Dexia had to be nationalized and then wound up soon after.

This time around, the tests do not even consider the possibility that the Eurozone could end up in a deflationary debt spiral. That’s the real threat everyone’s most terrified of, given that the ’recovery’ is losing momentum.

It’s a near mathematical impossibility that the weakest members of the Eurozone can grow their way out of their debt. If deflation takes hold—as it has already in Greece and Cyprus, and is close in Portugal, Spain, and Italy—all bets are off.

Right now, the omens aren’t good. The ECB’s monetary stimulus is not being transmitted to the countries where it’s most needed. The Spanish and Italian corporate sectors, dominated by smaller firms that are dependent on banks for finance, must pay much higher borrowing costs than small firms in northern Europe. In May, household loans in Europe declined at the fastest rate ever recorded—and the largest decline in lending to non-financial corporations occurred in Italy and Spain.

Since ECB president Mario Draghi said he’d do “whatever it takes” to save the euro in 2012, real inflation-adjusted lending rates for nonfinancial businesses have actually risen steadily. In Spain, rates are back up to their 2009 peak:

The Eurozone remains unstable, because its monetary system is flawed. The euro allows stronger countries like Germany to benefit from lower borrowing costs, capital inflows, and the immigration of skilled workers. Meanwhile, higher real interest rates in weaker countries push them ever deeper into deflation. Unless the Eurozone is prepared to become a United States of Europe and raise taxes at a European level, Europe will never experience an economic convergence.

But we know that Europe’s politicians are never going to give up their national sovereignty to create a genuine fiscal, political, and monetary union. They couldn’t even agree to share risk across national lines by forming a proper banking union.

As growth slows, the ECB is getting desperate. It lowered its benchmark interest rate to 0.15% and introduced negative interest rates on bank deposits in June. Neither will make much of a difference. Nor would quantitative easing, even if the ECB could overcome Germany’s opposition to it. Businesses and consumers are already maxed out, and the ECB has already monetized banks’ excess collateral.

We learned from the Latin American debt crisis in the 80s that a country couldn't overcome a debt crisis without addressing its debt overhang. The Brady Plan accomplished this for Latin America in the early 90s. But Europe has yet to realize it. The euro crisis is now in its fifth year, and investors should brace for sovereign defaults.

Perhaps Italy and Greece will force the issue. History shows that heavily indebted countries are most likely to default, once they have achieved primary budget surpluses—like Italy and Greece have. In the face of 26.7% unemployment and growing political extremism, the temptation to quit the euro must be growing.

The belief that the euro has been saved is lulling investors into taking on too much risk, as they did in 2007. Whatever the outcome of the EU’s stress tests, it’s only a matter of time before the Eurozone debt crisis re-erupts.