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THE CONTAGION EFFECT

Greece's debt crisis could spread across Europe

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By Neil Irwin
Washington Post Staff Writer
Friday, May 7, 2010

MADRID -- A third straight day of decline in world financial markets on Thursday was vivid evidence of a scary proposition: That the fiscal crisis that began in Greece months ago is spreading across Europe like a virus, causing growing doubt even about the fates of nations with far more manageable levels of government debt.

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It is called the contagion effect, economists' metaphor for the rapid and hard-to-predict spread of a financial crisis, and it's driven by the fragility of investors' perceptions. Contagion is a function of vicious cycles in which confidence in a country's ability to repay its debts falls. If investors lose piles of money on the debt of one country, they assume that owning the debts of other countries with similar finances might cause them to lose even more. So they sell their investment in the second country, which in turn must pay higher and higher interest rates to get any loans, which adds to its debt and creates a fiscal death spiral that can well move on to the next country.

Spain is in the path of the storm and at the mercy of global investors, who are operating under the twin pressures of fear and greed. The country has less debt relative to the size of its economy compared with the United States or Britain, but contagion can threaten even countries that have managed their government debt responsibly if investors change their views about the country's future deficits or ability to handle debt.

The odds of a full-blown sovereign debt crisis have risen significantly over the past two weeks and especially after the market turmoil Thursday, such that Europe in 2010 looks increasingly like East Asia in 1997 and 1998, when a currency devaluation in Thailand sparked a broad crisis in South Korea, Indonesia and elsewhere.

Once a panic starts and contagion is spreading, it often takes dramatic government action to reverse the tide -- including external bailouts and steps to address the underlying cause of the crisis that are more aggressive than those needed in a non-panic situation.

In the case of Asia in the late 1990s, it took a wall of money from the International Monetary Fund and the United States to arrest the series of crises, combined with painful austerity measures in the nations involved. Banking panics have similar dynamics, and during the 2008-2009 financial crisis, the U.S. government stepped forward with the $700 billion Troubled Assets Relief Program, a series of unconventional lending efforts from the Federal Reserve, and stress tests for major banks that required many of them to raise more private capital.

One lesson that could apply to the current situation is that a large-scale intervention from unaffected countries or the European Central Bank could ultimately be needed. Another is that government officials in the affected countries might need to promise more aggressive budget cuts than they would have if the situation hadn't become a market confidence game.

"You have to overdo the fiscal consolidation measures to convince people that you are serious," said Rodolfo G. Campos, an economist at IESE Business School in Madrid.

On Thursday, Jean-Claude Trichet, head of the ECB, said there was no discussion at a bank policymaking meeting about buying countries' debt -- a decision that would mean essentially printing money to fund borrowing by Greece and other at-risk countries.

That drove up borrowing rates for Greece, Spain, Portugal and other nations viewed as in financial trouble, and it drove the price of the euro down as low as $1.25 -- down from $1.27 Wednesday and $1.35 three weeks ago -- as investors betting on continuing economic turmoil in Europe shifted their money to dollars.

European stock markets fell, with the British market off 1.5 percent, France's down 2.2 percent, Spain's down 3 percent and Italy's off 4.3 percent. The Spanish stock market has dropped 11 percent since Monday.

Analysts had hoped the ECB might use its essentially limitless ability to create money to stanch the crisis, though doing so could hurt the long-term credibility of the central bank as an inflation fighter that does not yield to politics.


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