This is just to record my thoughts, so I can look back on this and see what I got right and what I got wrong. Or at least, what I changed my mind about.
The Euro was a mistake. I hoped (and still hope) to see the Euro dissolved. But the Euro is now stronger than before. With enemies like Syriza, the Euro does not need friends. The government of Greece made a bad situation (that was maybe slowly improving a little) worse. And it will get much worse in the future, regardless of the vote in the referendum. If this is what an exit from the Euro looks like, who would want to follow Greece in exiting the Euro? And the perceived willingness of the ECB to do open market operations was probably what nullified the Greek threat to destroy the Euro unless it got what it wanted.
Monetary policy is important. What we have been seeing for the last few years is the effect of a monetary policy that was too tight for Greece. It caused a bad recession. But a monetary system that breaks down completely is far worse than bad monetary policy, and the monetary system in Greece is breaking down. Currency is extremely inconvenient for some transactions. And there isn't anywhere near enough currency to satisfy the demand. So the recession is getting worse and will get much worse. The Lucasian olive trees are still there, and still yielding fruit. But it's hard to trade olives for apples without some sort of functioning monetary system. A recession is first and foremost a fall in the volume of trade caused by an excess demand for the medium of exchange. Any fall in production and employment is a side-effect of the fall in trade. We are going to be seeing some very big side-effects.
I do not know whether Greece will now stay in the Euro or leave the Euro. The most likely outcome is a situation so messy that it can best be described as "neither". Network externalities make it hard to introduce a new money, even for a competent government that has the trust of its people. But with tax receipts falling even further, I think the government will be forced to issue scrip to cover basic expenditures, and that scrip may circulate as a medium of exchange, to some extent, alongside the Euro notes. And the banks won't be able to issue Euros any time soon, regardless of the vote in the referendum.
An agreement (like most trades) is an exchange of promises. It's hard to get a good agreement if the people you are negotiating with don't trust you. The Nash bargaining solution in a cooperative game (with credible promises) is normally better for both players than the Nash equilibrium in a non-cooperative game. If the Germans had trusted the Greeks, they could have offered an agreement that would have been better for both Germans and Greeks. But the Germans did not trust the Greeks. It seems they trust them even less now. It's not obvious to me the Germans are irrational in this.
If you are a member of the (Euro) club, you can try to change the rules of the club. But if you fail to persuade the other members to change those rules, you either follow those rules in good faith, or else leave the club. A good club should also have rules for members who want to leave the club, but if it doesn't have those rules, you just politely walk out the door.
I think Greg Ip [link? Found it.] is right about the mistake made by economists like me. We underestimated the popular support for the Euro as a political symbol of identity, despite all its economic disadvantages. Playing golf hurts your back, but you want to be a member of the golf club because of who the other members are and the sort of people who are not members.
Or maybe you could argue that the Euro is a bad monetary system, but Greeks believe that a monetary system run by Greeks would be even worse in practice, and that's why they want to keep the Euro.
Worthwhile Canadian Initiative 
Bob and Frank,
Learn something, read more. Stop making things up to explain away facts that you don’t understand.
The US federal government is not necessarily going to bailout Puerto Rico, any state, city or municipality (technically it’s the creditors who get bailed out). The same is true for Canada. The market knows this. As a result, investors demand extra yield for debt that has a higher chance of default. Higher interest rates reflect higher risk. Each borrowing unit in North America has a credit rating – it’s not just a carbon copy of the American or Canadian federal government’s credit rating. If Illinois defaults, Illinois bond holders will not get paid back.
People keep saying that a currency union needs fiscal union, but it is simply not true.
Avon,
The question you asked:
“Why is there an interest rate spread between bonds issued by different American states?”
My answer:
In part because of the federal tax treatment of interest received on those bonds based upon who holds that debt.
I don’t deny that state debt carries credit risk with it. However, measuring that credit risk by simply looking at interest rate spreads between bonds issued by different states will not be an accurate measurement.
Your implication is that interest spread is a function of credit risk. My answer is that interest spread is a function of a number of variables, credit risk being one of them.
“The US federal government is not necessarily going to bailout Puerto Rico, any state, city or municipality (technically it’s the creditors who get bailed out). The same is true for Canada. The market knows this. As a result, investors demand extra yield for debt that has a higher chance of default. Higher interest rates reflect higher risk. Each borrowing unit in North America has a credit rating – it’s not just a carbon copy of the American or Canadian federal government’s credit rating. If Illinois defaults, Illinois bond holders will not get paid back.”
A couple of points.
First, don’t be a d!ck.
Second, you haven’t provided any evidence to support the proposition that borrowing costs vary significantly amongst US states and Canadian provinces. Frances posted the following study a few years ago which suggests that the gap is much smaller than I would have thought, based on the intrinsic economic capability of Canadian provinces: http://www-2.rotman.utoronto.ca/~booth/Provincial%20debt.pdf.
Third, is it your contention that Canada and the US aren’t fiscal unions? That other countries with their own currencies aren’t fiscal unions (inherently a unitary state is a fiscal union in the sense that the unitary government does everything), and most federal states have some degree of federal fiscal policy)? Bold statement.
Finally, a fiscal union doesn’t neccesarily imply that a federal government will bail out subnational governments. The US clearly has a fiscal union (and Puerto Rico is clearly part of it, given that a significant portion of its spending is funded by US federal grants and subsidies), and has consistently not bailed out various bankrupt subnational governments (mostly at the city level, New York, Detroit, etc. – come to think of it, New York and Michigan state can also be thought of as fiscal unions, but haven’t bailed out their cities).
What a fiscal union does imply, however, is that government spending in a particular subnational region is not solely a function of local government revenue (basically Majromax’s point). Even if Detroit can’t pay its civil servants, federal and state civil servants still get paid, state and federally funded health care or education still gets provided, old people still get their social security checks. Moreover, the existence of a fiscal union, even if it doesn’t eliminate the risk of default, at least reduces it, since federal transfers to subnational governments allow subnational budgets to ride-out local economic disruptions (witness the very narrow spreads in bond yields between Canadian provinces). A fiscal union provides a shock absortion mechanism which replaces monetary policy as a means of dealing with economic shocks. The Euro members have neither mechanism at their disposal, so it was only a matter of time before one of them crashed. I suspect Greece won’t be the last.
“People keep saying that a currency union needs fiscal union, but it is simply not true.”
No one is saying that a currency union NEEDSa fiscal union. Had you “read more” of my comment, you would have noted that I happily conceded that you can have a currency union without a fiscal union – we have one in the EU. What people do say, dating back to Robert Mundell’s work on optimal currency areas, is that a currency union without a fiscal union is likely to be unstable. That’s particularly true in a currency union (such as the Euro zone) which lacks other attributes of an optimal currency area (inter-regional wage flexibility, significant labour mobility, a similar business cycle, a common identity) The EU experience is bearing that prediction out.
Nick, that’s quite a states-as-single-entities rules-are-rules kind of a way of looking at things which implies important value judgements which you don’t bother to discuss or justify but which you really should because this is important stuff and your blog probably has some small influence over how people think about this.
“If this is what an exit from the Euro looks like, who would want to follow Greece in exiting the Euro?”
This isn’t what an exit looks like, this is what staying looks like. You’d need at least a year or two after exit occurs to see what an exit looks like.