As is often the case this deserves a more detailed response than I am going to give it but I wanted to address these observations by Tyler Cowen before they went cold.

Tyler says

The population of Germany is about 81 million, if you wish round that up to about 100 million, if you include some of the smaller Triple A countries.  In other words, that is a guarantee of $30,000 per German, or $120,000 for a household of four.  Note in passing that an ECB guarantee either requires recapitalization of the central bank or a higher rate of inflation, unless you think the whole thing is a self-sustaining free lunch and all the liquidity problems would vanish (unlikely, at this point).  In any case a guarantee has to at least put resources on the table.

The core issue is that there are no lunches on the table. Italy for example currently runs a primary surplus. The central government is not extracting any resources beyond its ability to tax. What is at issue is competing private claims on private sector resources.

To get to the heart quickly imagine this: The Italian government looks at the bond market and says, “Oh screw us? No, no, no my friend, screw you.” Default. Boom. We’re outa here. [Mario Monti drops microphone, exits stage right]

What’s the stage one effect for the Italian central government? They move from a budget deficit to a budget surplus. That is, currently they are running a primary surplus. They don’t need the bond market to fund their operations. They need the bond market to fund the claims of bondholders.

The problem comes from the fact that the financial system is not indifferent to the distribution of private claims. This is why Europe faces a crisis. I remember William Buiter arguing in the middle of the subprime collapse that the US could not go into recession because housing wealth was not wealth.

The mistake he made then and the issue now is that total wealth or productivity is not what matters. Vastly more important for the functioning of the financial system is that there are no sudden unexpected changes in the distribution of wealth.

That is, to say its not a matter of some how getting a free lunch. It’s a matter of making sure that the lunches we do have are distributed in the manner in which people expected them to be distributed.

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