By Neil Irwin and Madrid
THE THIRD straight day of decline on 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 about the fates of even nations with far more manageable levels of government debt.
It is called the contagion effect, an economist's 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 means that country has to 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 than the United States or Great Britain, but contagion can threaten even countries that have managed their government debt responsibly.
The odds of a full-blown sovereign debt crisis have risen significantly over the past two weeks and especially after the market turmoil this week. Europe in 2010 looks increasingly like East Asia in 1997 and 1998, when a currency devaluation in Thailand sparked a broad crisis in Korea, Indonesia, and elsewhere.
Once a panic starts, 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.
Banking panics have similar dynamics and during the 2008-2009 global financial crisis, the US government stepped in with the $700 billion Troubled Assets Relief Program, which included stress tests for major banks that required many of them to raise more private capital.
Large-scale intervention from unaffected countries or the European Central Bank might ultimately be needed.Jean-Claude Trichet, head of the European Central Bank, said this week the bank had not discussed buying countries' debt - essentially printing money to fund borrowing by Greece and other at-risk countries.
This revelation 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 $US1.25 ($A1.40) - down from $US1.27 Wednesday and $US1.35 three weeks ago - as investors betting on continuing economic turmoil in Europe shifted their money to dollars.
Analysts had hoped the European Central Bank 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.
Still, Mr Trichet did not explicitly rule out buying debt, saying only that the concept was not discussed. This suggests that the idea is not out of the question, if the situation became worse.
And that may happen, with the European market sell-off being followed by an even more dramatic decline - and partial rebound - in the US.
The herd-selling on both sides of the Atlantic is typical of financial contagion and shows how these crises feed on fear, not just economic basics.
In the case of Spain, the country's public debt only adds up to about 70 per cent of its annual gross domestic product, compared with 84 per cent in Germany, 82 per cent in Britain, and 94 per cent in the US.
But with 20 per cent unemployment and a generous set of social welfare benefits, Spain is running a higher annual budget deficit - 11 per cent, compared with 2.3 per cent in Germany. So to keep its debt from rising significantly, Spanish leaders need to rein-in spending or raise taxes to reduce annual deficits.
Normally, they would have years in which to make that transition; after all, the debt wasn't going to explode overnight. But since it became clear to global investors that Greece was more indebted than they realised and that the country may not be able to pay back what it owes, buyers of government bonds have been taking a hard look at countries with debt problems of their own.
And they have focused on Spain, Portugal, Italy and Ireland.
Thus, while Spain may have more in common with Greece for sunny weather and nice beaches than its level of indebtedness, markets have turned on the nation.
''If you look like somebody who is sick, you get sick,'' Mr Campos said.
WASHINGTON POST