The forces of contagion in the eurozone appear unstoppable. On Thursday investors drove yields on both Italian and Spanish debt to new highs, as fears grew that last month’s Greek rescue deal would prove insufficient to stop Europe’s financial rot. Without swift action from the European Central Bank, this will prove to be a contagion process with a disastrous end.
Why do we face these problems? Government bond markets in a monetary union are inherently fragile. Eurozone nations issue debt in a “foreign” currency, over which they have no real control. As a result, they cannot guarantee to the bondholders that they will always have the necessary liquidity to pay out the bond at maturity. States which issue their own bonds, however, can guarantee that the cash will always be available, because they can always force the central bank to create the money. And there is no limit to the amount of money a central bank can create.
This situation makes bond markets in a monetary union unusually prone to forces of contagion, very much like in banking systems. If one bank experiences a solvency problem, deposit holders start doubting the solvency of their own bank, and run to convert their deposits into cash. When everybody does this at the same time the banks will not have enough cash. This banking system instability was solved by mandating the central bank to be a lender of last resort – and the neat thing about this solution is that, when deposit holders are confident that it exists, it rarely has to be used.