A fine mess and fine description

This is one of the best descriptions I've seen of the current situation, though a little economicsy:

"If the EU lets Greece fail, it's like letting Lehman fail in 2008 or the Bank of United States fail in 1930. It sends out a signal. The dithering of the EU may already have sent out such a signal. They may already have altered expectations and behavior. The rescue package may lack believability for the moment. It may not have sunk in quite yet.

The rescue team, which consists of the stronger countries and the IMF, are damned if they do and damned if they don't. Instead of banks being insolvent with runs occurring on them as in the 1930s and 2008, we have whole countries being bankrupt, but their paper is held by banks in France and elsewhere, so there is a contagion thing to worry about. If the EU lets default happen, there is a run against all the bonds of all the weaker countries. Their yields rise, and they have to default too, and then that weakens a host of banks and others who hold the paper, and then they demand to be bailed out. If instead they rescue Greece and others, then the rescuing governments have to issue more debt, or else the IMF does too, or else the ECB gets into the act too, and this weakens the stronger countries and drives down the euro. So, either way, there are problems. It appears that the rescue option has been invoked, although tardily and reluctantly. This means that the governments are rescuing the bondholding banks and whoever else holds the Greek paper. That's the bailout here. This is preferable to the rescuers as compared with an outright default which then starts a contagion via the bond yields rising sharply which induces country bankruptcies and defaults.

The deflation at work here has already happened. It's that the values of loans held by banks have declined a great deal, and are below the values of their liabilities. The fractional-reserve banking system doesn't work today and it didn't work in the 1930s and at other times when depositors demanded cash or gold and the banks couldn't liquidate assets or gain access to cash flows to pay them. Even with the Fed turning bank loans into cash, the FDIC has to keep closing banks every week because they are way below any regulatory standards of operation.

Central bank inflation is necessary in this kind of a fiat money-fractional-reserve banking system to prevent the whole system from collapsing due to flight to safety. More money is like a blood transfusion to a patient who is losing blood. But this doesn't resolve the insolvency in the system. The regulators have what is called "forbearance." They ignore the insolvency and do not enforce mark to market. They then close the worst banks and hope that the rest make enough money to rebuild their liquidity. Gradually, as the banks use reserves that cost them 0% to invest in U.S. Treasuries at 3.5%, they make some money. The Treasury market stays firm for this reason. The Fed keeps rates low for this reason. The banks build up potential liquidity by holding treasuries. In a few years, they sell these and start making more loans, and price inflation starts appearing. Meanwhile, the economy limps along. This is the muddle-through scenario.

Full Article

Another article that explains what could kick the Greek crisis over the edge.