By Neil Irwin
Greece sneezed, and now most of Europe has a cold. The European debt crisis has already spread like a virus from Greece to Ireland, and other countries are now at risk: Portugal, Spain, and Italy are probable candidates for financial problems. Economists call this the “contagion effect.” How does this spread? Some of it has to do with confidence. When investors see one country encounter financial problems, they may doubt the health of other countries that seem to share economic or even political characteristics.
Contagion also has much to do with actual economic links among countries. Researchers have identified financial ties in particular as responsible for the “fast and furious” spread of crisis from one country to another. Trading activity between countries, however, can propagate economic sickness more slowly.
When an ailing country becomes over extended and unable to handle its debt, banks and other financial firms that have lent it money could be exposed to major losses. This could unsettle the home country of the banks or even spread the troubles to a third country. That can occur, for instance, because banks may try to cover their losses in one country by calling in loans in another.