The Sovereign Debt contagion continues in Europe. The bond investors in Europe are not buying the EU/IMF Irish bailout. These investors rightly see the issue of sovereign debt as so risky that they are losing confidence rapidly in the sovereign debt (aka bond) markets.

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When this occurs, yields on the bonds rise to attract investors, this gives the investor an incentive to risk his money. The riskier the debt is, the higher the yield hast to be to attract investors. The higher the yield the higher the interest rate. The higher the interest rate, the more expensive it is to borrow for everyone, the state and businesses (this causes inflow of foreign capital that might be chasing higher interest rates than in their domestic market). The more expensive it is to borrow, the more costly the sovereign debt. The more costly the sovereign debt, the more money is needed for the economy to pay it back.  The more money used to pay debt is less in the actual economy creating wealth.

The other side of the same coin is capital flight, that’s when the money just up and leaves the market.  In this case, the money is leaving the EU (and Asia after the NORK incident) and piling into the American bond market.  This drives bond yields down in the US, as investors see US sovereign debt as a better risk than Europe and Asia. Lower yield means less expensive debt…the opposite of the above cycle.

Lets look at Monday’s headlines (this is an excellent and very concise article):

Contagion strikes Italy as Ireland bail-out fails to calm markets

The EU-IMF rescue for Ireland has failed to restore to confidence in the eurozone debt markets, leading instead to a dramatic surge in bond yields across half the currency bloc.

Spreads on Italian and Belgian bonds jumped to a post-EMU high as the sell-off moved beyond the battered trio of Ireland, Portugal, and Spain, raising concerns that the crisis could start to turn systemic. It was the worst single day in Mediterranean markets since the launch of monetary union.

The euro fell sharply to a two-month low of €1.3064 against the dollar, while bourses slid across the world. The FTSE 100 fell almost 118 points to 5,550, while the Dow was off 120 points in early trading.

“The crisis is intensifying and worsening,” said Nick Matthews, a credit expert at RBS. “Bond purchases by the European Central Bank are the only anti-contagion weapon left. It needs to act much more aggressively.

“The EU rescue fund cannot handle Spain, let alone Italy,” said Charles Dumas, from Lombard Street Research. “We we may be nearing the point where Germany has to decide whether it is willing take on a burden six times the size of East Germany, or let some countries go.”

Or let some countries go? The cracks in the EU continue to build. Can the EU collapse? Given what happens to any country that leaves the EU, it probably wont.

Some now see the eurozone as effectively operating at two speeds, with Germany, its biggest economy, leading the pack of stronger countries, and the weaker periphery nations failing to keep up – to an unsustainable degree. Having a “one size fits all” monetary policy means stragglers cannot devalue their currency to boost exports and stimulate growth, unlike, say, Iceland…

“Not only do we find it difficult to imagine how a nation could disentangle itself from the single currency (unscrambling the omelette) but we also take seriously the fact that the Maastricht Treaty envisioned entry into the euro as being irrevocable,” says Mr Derrick.

However, he says it is not impossible that a country could withdraw, should the attractions of leaving outweigh the penalties, such as the “inevitable” restructuring needed to offset the sharp fall in the value of the reintroduced currency, since the debt overhang would stay in euros.

That would mean the departing country would face exclusion from the international debt markets for years, he predicted.

And now the Euro is falling against the dollar (part of QE2 was to devalue the dollar, remember…).

Is there enough cash to bail out all of these countries?

In practice, the EU may only be able to deploy 255 billion euros of the 440 billion-euro European Financial Stability Facility, according to analysts at Nomura International Plc.

That’s because the rescue fund is financed by issuing bonds and in order to secure a AAA rating, governments agreed to set aside a pool of cash, depleting the total amount available to pump into economies. The rest of the bailout pool consists of 60 billion euros from the European Commission and 250 billion euros pledged by the International Monetary Fund.

“There isn’t enough official money to bail out Spain if trouble occurs,” Nouriel Roubini, the New York University professor who predicted the global financial crisis, said yesterday in Prague. While it’s “quite likely that Portugal” will be next in line for financial assistance, “the big elephant in the room” is Spain, he said.

At 9.3 percent of gross domestic product, Spain will have the largest budget deficit in the euro area this year after Ireland and Greece, the European Commission forecast yesterday. Portugal’s shortfall will be 7.3 percent of GDP.

When Roubini speaks, listen  He is very, very good at seeing well over the economic horizon.