May 7, 2010
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.
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.
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