The Financial Times reports that the European Central Bank (ECB) has warned of a “financial contagion” risk from concerns about the debt of some European governments. Many readers of this blog will recall that a similar concern was important in the late 1990s, when debt and currency problems seemed to spread among Asian and Latin American countries.

Financial contagion can occur in many ways. A modern financial system is highly interdependent, with financial corporations holding the liabilities of other financial corporations, often in foreign countries. Also, perceptions that a particular debtor might default on some of its debt can quickly lead to worries about similar debtors and financial instruments. For example, after the Penn Central Railroad went bankrupt in 1970, there was panic selling of commercial paper, leading to a near-collapse of the commercial paper market.

There are grounds for fears that the crisis that began in Greece could grow much further through some such contagion effect.  Indeed, another article in today’s FT describes how spreads between interest rates on the debt of financial and nonfinancial corporations and rates for government debt have generally widened in the past month in the United States and Europe. Draconian measures aimed at closing budget gaps could exacerbate the contagion effect, since they increase fears of sharply reduced growth around the world.