LONDON - Becalmed by a likely interest rate cut as soon as next month, euro zone government bond markets seem serene - but the European Central Bank continues to fret about leftfield shocks.

Cosseted largely by more than a decade of extraordinary ECB monetary policies and direct bond market interventions, the traumatic euro sovereign debt crisis of 2010-2012 that threatened to blow the currency bloc apart now seems to many like a bad dream.

Painful Greek debt restructuring aside, resolving the then thorny issue of how a multinational ECB intervenes to smooth internal debt ructions was perhaps at least as important as anything to do with national debt sustainability concerns.

Even during the more recent thunderbolts of 2020's pandemic and the Ukraine-related energy and defense blow that seeded severe inflation and interest rate spikes, euro government debt premiums over Germany's baseline have remained relatively calm.

And as one of the steepest ECB rate rise campaigns in the euro's 25 year history now heads into reverse, those risk premiums are now emerging mostly unperturbed despite a regional flirtation with recession and a reduction of more than a two trillion euros ($2.17 trillion) in the central bank's bloated balance sheet over just 18 months.

Greater euro zone political and economic cohesion - in part due to geopolitical threats to its east - and faith in ECB dexterity has played a key part. So too has relatively restrained budget management - at least when compared to the outsize U.S. fiscal blowout of recent years.

But in its twice yearly Financial Stability Review, the ECB on Thursday wrung its hands about the lack sufficient debt reduction, excessive investor risk taking and the threat to the whole piece from any further geopolitical shocks.

"The lack of envisaged fiscal consolidation, combined with high debt levels, makes national budgets vulnerable to intensifying geopolitical tensions should these require increases in spending on defense, for example," it said.

And it opined that rising defense bills may make it more difficult to accommodate additional investment in areas such as climate change and digital technology - sapping euro zone growth potential further out and exposing debt piles still higher than before the pandemic.

"Structural headwinds to potential growth, from weak productivity for instance, are raising concerns about longer-term debt sustainability - making sovereign finances more vulnerable to adverse shocks and elevating risks to the financial stability outlook."

While it's the job of these sorts of financial stability reports to flag up 'worse case' scenarios, the ECB went on to fret about how investors' "low risk perceptions might mask underlying vulnerabilities and lead to excessive risk-taking."

"Because of the rise in interest expenses and still-elevated debt levels, some euro area countries may experience significant spread widening if they are unable to consolidate their fiscal positions," it said. "This may prove challenging, given the subdued economic growth outlook."

"WAR-GAMING" DEBT RESTRUCTURING

Cutting interest rates from next month takes the pressure off all that of course - even though there's a heated debate among private sector economists about whether the ECB itself over-reacted to the global inflation surge with excessive tightening that sapped that very investment spending and hurt growth potential.

Either way, evoking thoughts of 'debt sustainability' in the event of external political shocks raises uncomfortable memories and, for some, unfinished planning business from the existential euro crisis more than decade ago.

In a recent book "Euroshock" - which recounts the protracted and sometimes chaotic Greek debt restructuring of 2012 in which he was one of the key private sector negotiators - veteran financier Charles Dallara details the alarming lack of preparedness among euro nations on how to resolve the impasse.

There was then no advance plan on how sovereign bailouts would pan out or where the International Monetary Fund might fit in, he recalls, and an early unwillingness to even contemplate what became the largest sovereign debt restructuring in history.

While much has been addressed in the interim and Greece has since returned comfortably to the bond markets - with its debt now trading with less of a risk premium than Italy's - Dallara fears there's still no adequate institutional framework to deal with a repeat in the event of a future shock - however unlikely.

"The stability mechanisms of Europe would still be inadequate to cope with a major debt crisis in a much larger country such as Italy or France," Dallara told Reuters. "The IMF has also been reluctant to address the issue of how you engage in an adjustment program with a country that's part of a monetary union like the eurozone."

A former long-standing head of Washington-based bank lobby the Institute of International Finance, he reckons any adjustment program should have been euro wide with a mutualization of the obligations related to the funds necessary to support the countries in stress - and that never happened.

What's to be done? Make hay while the sun shines is his suggestion.

Dallara said that while calm prevails another sovereign debt crisis should be "war-gamed" by the multilateral regional institutions and include market participants. That then would assess what financing "envelope" could be made available to deal with it and from where, who would direct any such program and whether the debtor country should have a fair seat at the table.

"Are we entering a period of heightened vulnerability around fiscal imbalances? I think the answer is we probably are."

"We are entering a phase when the rebalancing of fiscal accounts will become more of an issue as quantitative easing retreats and as interest rates now give governments hopefully a better chance of building some consolidation of their fiscal accounts."

The opinions expressed here are those of the author, a columnist for Reuters.

($1 = 0.9202 euros)

(Editing by Josie Kao)