By Ambrose Evans-Pritchard

LONDON, England - August 2, 2011 - The European money markets have begun to seize up as pressure mounts on the Italian and Spanish banking systems, tracking the pattern seen during the build-up towards the financial crisis in 2008.

The three-month euribor/OIS spread, the fear gauge of credit markets, reached its highest level in two years today, jumping 7 basis points to 40 in wild trading.

"Europe's money markets are undoubtedly starting to freeze up," said Marc Ostwald from Monument Securites. "It's not as dramatic as pre-Lehman but it is alarming and shows the pervasive degree of fear in the markets. People are again refusing to lend except on a secured basis."

The credit stress was triggered by fresh mayhem in the southern European bond markets and ominously in parts of the eurozone's soft core as well, including Belgium. Spanish yields pushed further into the danger zone to 6.42%. Italian debt reached a post-EMU high of 6.22% before falling back slightly on reports of Chinese buying.

"We have a revolt taking place by foreign investors in these bond markets," said Hans Redeker, currency chief at Morgan Stanley. "There have been hardly any purchases for several months. We are seeing net disinvestment because people fear that these countries lack the potential to grow their way out of the problem, and risk falling into a Fisherite debt trap."

Redeker said the eurozone needs a lender-of-last resort along the lines of the U.S. Federal Reserve to backstop the Spanish and Italan bond markets. The European Central Bank cannot easily step into the breach under its current legal mandate and treaty authority.

"The eurozone faces a very big decision: it either creates a central fiscal authority or accepts reality and starts to think the unthinkable, which is to cut the currency union into workable pieces," said Redeker.