One of the more important insights about the state of the European economy right now comes from postcode data in the US. In their magnificent book House of Debt, Atif Mian and Amir Sufi find that what is outwardly disguised as a credit crunch is in reality a fall in demand for loans.

Their analysis lends credence to the idea of a balance sheet recession: the notion that indebted households and corporations do not care about cheap interest rates but just want to offload debt. When that happens, monetary policy becomes ineffective. Richard Koo of the Nomura Research Institute saw exactly the same phenomenon in Japan 20 years ago. It is still the best explanation of what happened there.

Mr Mian and Mr Sufi seek to provide a partial answer to this question: why has US growth been so weak even after the clean-up of the banking system? In Europe the situation is similar, only worse. It has not even done the clean-up. It has taken the eurozone six years after the collapse of Lehman Brothers to start what the European Central Bank euphemistically calls the ‘comprehensive assessment’. We will not know the results until the fourth quarter. The stress tests of 2010 and 2011 were discredited because they failed to flag the dangers ahead. I expect a slick presentation this time - a triumph by PowerPoint. What we know so far is not good. For example, the ‘adverse scenario’ is more optimistic than the ECB’s own inflation forecast. They have taken the stress out of stress test.

The implication of book’ House of Debt’ and the S&P study is that the conventional market view of the post-crisis environment is dead wrong. The most likely trajectory is a long period of slow growth, low inflation, and a constant threat of insolvency and political insurrection

But according to Mr Mian and Mr Sufi, none of this may matter as much as we think. Moritz Kraemer of Standard & Poor’s came up with corroborating evidence last week, when he did the maths on private sector debt in Europe. His analysis reads like a European version of House of Debt - only more scary. Mr Mian and Mr Sufi at least described the past; Mr Kraemer explains the future. The Europeans have barely begun to deleverage. In Spain and Ireland the process has at least started. But it will take years, maybe decades, until it is completed.

Take Portugal, which is about to exit its support programme from the European Stability Mechanism and the International Monetary Fund. Its private sector debt reached a peak of 226.7pc of gross domestic product in 2009. It was still 220.4pc at the end of 2013. S&P has run a simulation under which Portugal’s private debt could fall to 178pc of GDP by 2020.

That is still a big number. But it may be too optimistic. Portugal and other peripheral eurozone countries will need to deleverage and simultaneously deflate their prices to become more competitive. What makes it even harder is that inflation in the eurozone has been falling. Low inflation raises the real value of future debt, and reduces the ability to cut prices.

Is it feasible? Today’s market consensus says yes: the eurozone crisis is over. Yes, there was some upheaval at last month’s European parliament elections, but we will muddle through politically. Surveys tell us that European businesses are becoming optimistic. Investors are exuberant. I am often hearing how great the mood in Spain seems to be. All’s well that ends well.

The implication of House of Debt and the S&P study is that the conventional market view of the post-crisis environment is dead wrong. The most likely trajectory is a long period of slow growth, low inflation, and a constant threat of insolvency and political insurrection. If the private sector were to reduce debt in such an environment, certainly on the scale as suggested by S&P, it would be a lot harder and possibly bloodier than any of the adjustment we have seen so far.

When the Japanese private sector began to deleverage in the early 1990s, the government increased its debt to absorb the shock. The Europeans did the same to some extent during the crisis as well. Spain, for example, was able to maintain large deficits. But from 2016, the strictures of the eurozone’s fiscal compact will kick in and force an acceleration in fiscal consolidation. The new fiscal rules will amplify the effects of private sector deleveraging. The bottom line is that the total post-crisis adjustment will be much more brutal than it was in Japan 20 years ago.

In such an environment I would expect the political backlash to get more serious. More people in more countries will question the benefits of the EU and the euro in particular. Even if deleveraging could work economically - which is not clear - it may not work politically. My guess is that if the Europeans had to choose between deleveraging and default, they will pretend to do the former and end up with the latter. By reducing political instability, they will end up increasing financial instability.

I am just not sure that investors understand the risks. Nor do they seem to understand the implications of recent EU legislation establishing a new pecking order of who pays how much and in what order when a bank fails. When the house of debt collapses, it is they, not the taxpayers, who come first.

Published in Dawn, Economic & Business, June 23rd, 2014