This is something I know I don't understand. Compare the following two statements:
A: "Some Eurozone countries have higher interest rates on their government bonds, reflecting higher perceived risk of default. This raises all interest rates in those countries, and so reduces aggregate demand in those countries."
B: "Some Canadian provinces have higher interest rates on their government bonds, reflecting higher perceived risk of default. This raises all interest rates in those provinces, and so reduces aggregate demand in those provinces."
I believe that B is false. I see no reason why the risk of default of a provincial government should cause higher interest rates for private borrowers in that province. Replace "province" with "municipality", if you like, and it's even more implausible. If my municipality has too high a debt, why should that affect the rate I pay on my credit card? Just because the province or municipality in which I live defaults on its debt, doesn't mean that I will default on my debt. (Or does it? Are those default risks correlated? Bad times in a particular province or municipality may damage both government and private borrowers' ability to pay their debts. But some private borrowers should still be safer than the government, and will pay lower interest rates.)
But if B is false, why should A be true? Is A true?
I can think of one reason why A might be true but B false. If a Eurozone country defaults on its debt, it may also leave the Euro, issue a new national currency, and pay its debts in that new national currency . And if it does leave the Euro, and pay government debts in the new national currency, it will also declare that all private debts can be paid in the new national currency. And since the new national currency would immediately depreciate against the Euro, that would amount to a partial default. And, most importantly, that partial default would be perfectly correlated between government and private debt. So private interest rates would follow government interest rates higher one-for-one when that default risk rises. And since government default would imply private default, interest rates on private loans should never be lower than on government loans.
I don't see Canadian provinces issuing a new currency if they default (with the possible exception of Quebec?). Same with US states.
So, if we want to estimate the bond market's perceptions of the risk of a break-up of the Eurozone, don't just look at government bond yields; look at private bond yields too. If interest rates on private loans always rise one-for-one when government bond yields rise (relative to Germany), and if private loans always yield higher than government bonds, then that risk premium reflects the risk of leaving the Euro, rather than a simple default while maintaining the Euro.
Does that sound right?
(I haven't looked at interest rates on private loans across Eurozone countries, nor across Canadian provinces. Partly because I'm lazy, and incompetent at getting data; and partly because I want to state the theory first before peeking at the data, to avoid bias. Data nearly always give a fuzzy picture, and it's best if the person looking at the data isn't wedded to a particular theoretical interpretation.)