What is the 'Contagion Effect'?

By Derek Thompson

Following news coverage can be easy. Understanding some of the terms it uses, less so. In our Flashcard series, The Atlantic explains ideas you may read about but never see spelled out. In this installment, we explain the so-called "contagion effect" in Europe's financial markets.

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The News

Greece's debt crisis won't stay in Greece. It's quickly becoming Europe's nightmare. Newspapers often refer to Greece's inability to balance its own checkbook as a kind of "contagion effect" that could spread through the continent. How can a nation's debt be like a disease?

The Gist

First, let's think about debt. A country's debt is the accumulation of past deficits. It equals the total sum of promises to pay back the bonds, or loans, it sells to investors in order to run the country. If the country pays back the bonds on time, hunky dory. If it cannot, the country is in "default."

If debt is a promise, default is an acknowledgment that the country was lying, and the "contagion effect" is the paranoia that there are more liars.

Here's how it works: one country gets into trouble -- usually with some combination of high deficits and weak growth -- and becomes at risk of defaulting, or breaking its promise to pay back its money. Investors smell losses, and they look around to identify more trouble, assuming that countries with similar problems will suffer similar fates. Think of it as a kind of fiscal discrimination, or financial profiling. It doesn't matter if you're at risk of default. It matters that you look like some other country that is guilty of gross financial recklessness.

Suddenly, these targets of fiscal profiling (Portugal, Italy, Ireland, and Spain... for now) face investor discrimination. Nobody wants to lend them money. So they raise their interest rates to promise lenders more money later. But higher interest rates only make it harder to pay off their debt. In this way, the vicious cycle is self-fulfilling, like a "reverse-Tinker Bell effect": if investors don't believe in you, your financial credibility disappears.

The Debate

If country-by-country contagion is a loss of trust, its cure could be a larger body like the European Union saying: Trust me.

Here, another comparison is useful. In the Great Depression, when the banks looked unhealthy, depositors rushed to withdraw their money, emptying many banks' cash reserves and leading to their failure. (That was a kind of contagion, too.) So to prevent future "bank runs," the federal government created the Federal Deposit Insurance Corporation to reassure Americans that their money was safe. It was our way of saying: Trust us, the money will be there.

The European Union is trying to send the same message. It has created a trillion-dollar emergency fund to stand behind Greek debt in exchange for harsh requirements for Greece to raise taxes and cut spending. This will delay, but not dodge, a default in Greece. An austerity shock will shrink the Greek economy, depress income, hurt tax revenues and increase the country's debt burden as a percentage of GDP (a key indicator for investors). The EU's emergency fund might be big enough to solve an isolated Greek crisis, but it is not big enough to save Greece and inoculate the contagion that could spread to larger countries. In other words, the Eurozone is not strong enough to back up all of its weak member states' endangered promises. As a result, Greece will almost certainly default on its debt and might face the possibility of dropping the euro.

Contagion or no contagion, everybody knows that Greece lied.

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For more Flashcard posts:

The Basel III Accords

The Bush Tax Cuts

Cap-and-Trade

Carbon Pricing

The Contagion Effect

Deficit Spending (Stimulus)

The Oil Spill Liability Cap

Predator Drones

The Recovery Act

The Renewable Electricity Standard

Social Security Fixes

Unemployment Insurance

The Value-Added Tax

This article available online at:

http://www.theatlantic.com/business/archive/2010/05/what-is-the-contagion-effect/56858/