I haven’t spent nearly as much time thinking about the internals of Europe and Eurozone as I should. Mainly I have thought about ECB policy as a whole. However, there is this debate going on over what the individual countries as countries should do.

Its not clear to me, however, that for the PIIGS austerity would be contractionary.

I’ve written and erased several posts on this already but let me just lay down my primary areas of confusion.

In the case of the Eurozone, we see various government borrowing rates diverging from one another and from the interbank lending rate.  This tells me that these governments must be competing against other risky endeavors for funds.

Thus an increase in government borrowing does not lower the risk profile of the overall asset market. It does not mean a one-for-one swap in the interbank lending market. It does not – I don’t think – imply a proportional increase in the money supply even if monetary policy stays constant.

Thus an enormous amount of fiscal traction is lost right there.

Now you could say, doesn’t more borrowing by ANYONE pull on the money supply when the economy is away from full employment. On the one hand there is that effect but on the other hand borrowing in the high yield markets is going to have expectation and liquidity effects that get washed away in the low yield markets.

So, as Greece for example, borrows more money, it becomes less likely that it will pay back existing creditors. That makes existing bonds less liquid and more risky than they were before and so should have an offsetting increase in liquidity demand for holders of those bonds.

Indeed, under some set of parameters, it ought to be the case that Austerity could be expansionary. What you would need to happen is that reduction in liquidity demand for holders of existing bonds more than offset the decrease in borrowing.

Now, this is all very confusing at first glance because the tax base, the currency zone and the interbank lending markets are not the same. Presumably people can move their money in ways the would expose it or not expose it to taxation by the Greek government and the details of that might be important. Also, the exposure of various banks both in Greece and outside of Greece to Greek bonds will vary.

For example, I suppose it is possible to have a Greek bank with no exposure to Greek Government bonds. How then is that bank affected by Greek Government borrowing? I am not sure.