Greece's debt crisis could spread across Europe
By Neil Irwin
Washington Post Staff Writer
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.
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.
"Measures that damage the fundamental principles of the currency union
and the trust of the people would be mistaken and more expensive for the
economy in the longer term," said Axel Weber, a member of the bank's
policymaking council, according to Bloomberg News.
Still, Trichet did not explicitly rule out buying countries' debt,
saying only that the concept was not discussed. This suggests that the
idea is not out of the question if the situation becomes worse.
It did grow significantly worse since Trichet made his comments, with
the European market sell-off followed by an even more dramatic decline
-- and partial rebound -- in the United States.
The herd selling seen on both sides of the Atlantic is typical of
financial contagion and shows how these crises feed on investor
psychology, not just economic fundamentals.
In the case of Spain, the country's public debt only adds up to about 70
percent of its annual gross domestic product, compared with 84 percent
in Germany, 82 percent in Britain, and 94 percent in the United States.
But with 20 percent unemployment and a generous set of social welfare
benefits, Spain is running a higher annual budget deficit than those
other countries -- 11 percent, compared with 2.3 percent 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 realized 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's sunny weather
and nice beaches than its level of indebtedness, markets have turned on
"If you look like somebody who is sick, you get sick," Campos said.
Once borrowing rates rise -- Spanish 10-year bond yields have risen to
4.2 percent Thursday from 3.8 percent a month ago, though the shift in
Greece was far more dramatic -- a vicious cycle is underway. With the
price to roll over maturing debt higher, it becomes that much harder to
trim the budget deficit.
The contrasts -- and increasingly, comparisons -- between Spain and
Greece have become a fact of life for Spanish politicians and,
increasingly, ordinary citizens.
On the streets of Madrid, citizens take umbrage at being compared to the
Greeks, whose problems were caused by free spending and hiding their
degree of indebtedness.
"No, Spain is not like Greece. Our mentality is completely different. We
have a different mentality about working and developing things," said
Juan Manuel Heranz, 35, a maintenance technician at the airport.
"We're not Greece," said Alexandra González, 28. Her mother, Concepción
Lima, walking with her in downtown Madrid, chimed in: "But if we
continue on like this, we will be."