While Germany was locked in an embarrassing public spat with the European Central Bank last week over who should pay the price for a new Greek bailout, fresh evidence was emerging of the impact of the savage cuts Athens has already imposed on its increasingly restive citizens.

The number of people unemployed has shot up by 40% over the past 12 months; the jobless rate now stands above 16%. Among young people it's a devastating 42%, representing extraordinary human and social cost. Yet the government's latest plans envisage another four years of slash and burn, taking the deficit from 7.5% of GDP this year to 1% by 2015. It's extreme fiscal masochism, and it isn't going to work.

Growth is suffering: the economy expanded by a miserable 0.2% in the first quarter of 2011, official figures revealed. Over the past year, it has contracted by a total of 5.5%, and forecasters – including Greece's creditors, the IMF and the ECB – are expecting a further catastrophic decline of more than 3% over the coming 12 months.

Yet while Greece is swallowing its medicine, it's become increasingly clear – as many economists and investors have argued for months – that it's not just caught in a short-term cash crunch, but a solvency crisis. With its economy shrinking, Greece simply cannot afford to pay its debts.

The past year of pain has had very little to do with putting Greece's finances on a sustainable footing, and everything to do with papering over the catastrophic losses of the eurozone banks that indulged in an irresponsible lending spree in the run-up to the credit crunch.

As the venerable Leigh Skene of Lombard Street Research put it last week: "Writing assets down to fair value and then recapitalising banks should be the first priority in restoring economic growth after a banking crisis. Sadly, Europe went in the opposite direction and tried to ensure that no bank, regardless of how insolvent [it was], defaulted on its liabilities."

We've been here before. In the first of Adam Curtis's brilliant series of documentaries, All Watched Over by Machines of Loving Grace, broadcast on BBC2 over the past month, he described how the IMF – with the backing of Washington – wrought havoc on the Asian economies in the late 1990s. After a credit boom, driven by a frenzy of lending from the rich world's banks, turned into a crash, the IMF oversaw a series of bailouts, often insisting on savage budget cuts and "structural reforms" as a quid pro quo, emboldened by the idea that unleashing market forces would, in the end, lead to stability.

In many cases, including Indonesia, the Philippines and Thailand, the result instead was political and social chaos, but the west's banks, which had recklessly poured cash into the "Asian Tigers", didn't lose out. Even the IMF itself has since acknowledged that its prescriptions at the time made the problems worse. "While tough measures are needed to address deep economic problems, the conditions accompanying its programmes need to be more focused on the problems at hand, and it needs to be more conscious of the social impact of those programmes," it now says.

Yet the "rescue" of Greece, Portugal and Ireland – this time administered under the guise of European solidarity – followed precisely the same logic: private sector creditors must be protected; deficits must be tackled at a breakneck pace; no gain without pain.

Last week's intervention by Wolfgang Schäuble, the Germany finance minister, suggested that, in Berlin at least, reality is starting to dawn. Under pressure from domestic politicians, Germany is pressing for Greece's private-sector creditors, including Germany's own banks, to shoulder some of the burden of a fresh bailout through a "voluntary" debt swap, which would extend the lifetime of existing bonds by seven years. At the same time, Greece would step up its privatisation programme to raise short-term cash, and the "troika" of the IMF, the European commission and the ECB would find another €60bn (£53bn) or so.

Details are hazy, but such a "reprofiling" is just a default by another name, and the ratings agencies would be likely to see it as such. That would force banks holding Greek bonds, including the German banks, to write down their face value.

The ECB is vehemently opposed to the idea, partly because it is sitting on a pile of Greek bonds itself, and partly because it fears that a default, even one as widely anticipated as this, would create panic on a scale not seen since the Lehman Brothers bankruptcy in September 2008 – and we all know how that story ended.

The number-crunchers at consultancy Fathom reckon that a debt swap along the lines proposed by the Germans would mean a writedown of anything up to 36% on the value of Greek bonds.

That would probably require eurozone governments, including the French and Germans, to recapitalise their banks, at huge political and economic cost, but Fathom's Erik Britton reckons that even a default on this scale will not be enough to put Greek public finances back on a sustainable footing. "It needs to be twice that," he says. "If they're going to do it, they might as well do it properly."

He suggests a 70% default will eventually become necessary and that Greece will inevitably be followed by Portugal and Ireland. The all-out market panic that could result might well drag in Spain, too.

In other words, by shifting the pain on to the hapless taxpayers of Greece in order to cushion the eurozone's banks from the consequences of their own actions, all that Europe's leaders have succeeded in doing is exposing a political schism at the heart of the eurozone project – and sowing the seeds of an almighty market panic.

Even if Germany and the ECB can somehow patch up their differences and cobble together a short-term rescue deal for Greece, they will rapidly have to turn their attention to Portugal, Ireland, and – perhaps some time next year – back to Greece. And if the economics look grim, the politics of the euro project look even worse. Skene is exactly right to say that Greece is "the canary in the coalmine".