I started writing this post yesterday. It's already out of date. This is what I wrote yesterday; I will continue the post below.
Greece has now gone, at least in expected value terms. With bond yields increased to over 13% today, there is no way I can see Greece running a primary surplus big enough to pay those interest rates on its outstanding debt. When you have a debt/GDP ratio of 100%, every one percentage point permanent increase in interest rates increases the deficit/GDP ratio by the same one percentage point. Yields increased three percentage points just today. Yields in Portugal, Ireland, and Spain also rose, though by smaller amounts. Bond markets do not expect the cavalry to arrive on time, if at all.
Felix Salmon's depressing post explains why the German cavalry won't come. He talks about the consequences for European commercial banks, and their need for a rescue.
I'm more interested in how the European Central Bank will respond. I am certainly not an expert on the ECB, but when you can't find anyone who is an expert tackling this question, you have to make your own stab at it; even if you get things wrong.
Normal central banks buy things; that's how they create money. They print money, buy something with it, and that money then goes out into circulation. Mostly what they buy is bonds, the bonds issued by the government that owns the central bank. They do a little bit of colateralised lending to commercial banks on the side, just to fine-tune monetary policy, but it's usually small beer. And if they want to, and get the nod from the government that owns them, they can and will buy almost anything in an emergency, and lend to almost anyone against almost any colateral they feel like.
The ECB is not a normal central bank. It doesn't buy things. It lends to commercial banks against colateral of bonds issued by the Eurozone governments. It's a pawnbroker.
That's what I wrote yesterday. Now back to today. Yields on Greek bonds were at 18%, last time I checked.
It's not just Greece; I now think the Eurozone has gone. Not gone completely; it will live on in some form, just like the Holy Roman Empire, a shadow of the original, comprising maybe Germany, France, and Benelux.
Normal countries have their own central bank. In an emergency, if there's a run on the country's government bonds, the central bank can and will print money to buy unlimited quantities of those bonds. Provided those bonds are promises to pay the domestic currency, which the domestic central bank can print, the debt can always be paid. Just print whatever you have promised to pay. Another way of saying this is that a normal government, with its own central bank, does not have a binding nominal budget constraint. It can spend as much as it wants, if we measure spending in units of the domestic currency. It has a real budget constraint, measured in real goods and services, but only because the Long Run Phillips Curve tells you that printing too much money will only cause inflation, and the demand for money curve tells you there's a limit to how much money, in real terms, people are prepared to hold.
Of course, the consequences of printing a lot of money can be unpleasant. Inflation, depreciation of the exchange rate, and higher interest rates if you ever wanted to borrow again in future. But, if part of what caused your fiscal problems was recession, deflation, an overvalued real exchange rate, all caused by an excess demand for money, then a little bit of those side effects of the medicine is just what the country needs.
The Eurozone countries are not normal countries. They do not have their own, tame, central bank. They face both a real and a nominal budget constraint. They are vulnerable to "runs" on their government bonds -- an ugly feedback loop where solvency and liquidity crises reinforce one another through rising bond yields and increasing uncertainty about the true value of the bonds.
It's a mug's game trying to predict where contagion will spread. But I'm a mug.
The UK is part of the European Community, and has fiscal problems of its own. But it also has a central bank of its own. If my theoretical perspective is right, the UK will escape. So will other countries with their own central banks. Let's see.
And eventually what's left of the Eurozone will order the ECB to buy their government bonds, if ever they need it to.