I believe the probability of at least one sovereign default is disturbingly high, and the financial sector will be hard hit if one or more sovereign defaults materialize.  Bailouts will only postpone the day of reckoning, and a delayed reckoning will be more difficult.

We’ll be lucky if that is all we see. Multiple defaults are not out of the question, and the riots in Greece show how difficult it is to cut government spending.  Any social disturbances will only increase the economic pain and delay the ultimate recovery.  Multiple defaults too will exacerbate the economic problems.

Why would they do this? Countries join hoping to benefit from increased trade efficiency and access to markets. Are the benefits of joining the Eurozone worth the costs? That depends on how correlated a country’s economy is with the Eurozone economy.

If a country’s economy is highly correlated with the Eurozone economy, then that country will be happy with the European Central Bank’s monetary policy, and the fiscal constraints will likely be relatively minor irritants. However, if a country’s economy is not highly correlated with the Eurozone economy, the European Central Bank’s monetary policy could be counter-productive, and the constraints on fiscal policy can be painful. It can put a country in a bind.

That is exactly where countries such as Spain and Greece find themselves today, in a bind. If they could, these countries would follow a much more expansive monetary policy and an expansive fiscal policy. The price they pay for membership is higher unemployment, a slower-growing economy, and the potential for social unrest. For these countries, joining the Eurozone is starting to look like a deal with the devil. We may see some countries leave.