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.

A new report from the International Monetary Fund has turned attention, at least temporarily, from Greece to the larger potential problem of Spain, where unemployment is roughly 20 percent. A nice (if unsettling) summary:

Spain’s economy needs far-reaching and comprehensive reforms. The challenges are severe: a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness. Ambitious fiscal consolidation is underway, recently reinforced and front-loaded. This needs to be complemented with growth-enhancing structural reforms, building on the progress made on product markets and the housing sector, especially overhauling the labor market. A bold pension reform, along the lines proposed by the government, should be quickly adopted. Consolidation and reform of the banking system needs to be accelerated. Such a comprehensive strategy would be helped by broad political and social support, and time is of the essence.

The report, along with the government takeover of a faltering savings bank, seemed to get investors worried, even though neither was all that much of a surprise. Nonetheless, the cost of insuring Spanish debt rose, albeit to levels still far below that of Greece.

On the other hand, Spain was able to sell three- to six-month T-bills today, attracting bids worth more than twice the total offering. But the interest rate was a lot higher than in April. And last week a sale of 12 to 18 month T-bills fizzled.

Jan Kregel and Rob Parenteau, respectively senior scholar and research associate at the Levy Institute, offer this analysis of the current crisis in Europe, observing that investor behavior in this case isn’t just moved by animal spirits or orneriness:

This is about more than just testosterone counts. Some wing of the professional investing world is beginning to see the design flaws built into the eurozone from day one. And once the spy these flaws, they begin to realize the nature of the solution is something utterly different than what they are witnessing being rolled out before their very eyes. In the following 11 points, we highlight some of the key aspects of the eurozone predicament using the financial balance approach developed by the late Wynne Godley which we have explored in previous blog submissions, papers, and book chapters. Until more investors and policy makers can understand the true nature of the various predicaments facing the eurozone, and the inherent design flaws exhibited in the European Monetary Union and the (In)Stability and (Lack of) Growth Pact, odds are precious time will simply be wasted trying to make believe the shock and awe fix is already in.

Read the rest here.

Any time you talk about a contagion, it’s sensible to ask: where did the infection come from? The European debt crisis may look like it started in Greece, but really it began with the Stability and Growth Pact, the final framework of the European Monetary Union (EMU) that gave us the euro. That agreement is just too rigid to allow for the kind of fast, coordinated action necessary in a crisis. And because it launched the joint currency without any kind of federal transfer system, it made the new currency unsustainable. The euro’s founding framework thus contained the seeds of instability.

What’s really surprising about recent developments is that the imbalances in the euro-zone have caught the world by surprise. The recent trillion-dollar rescue package calmed the markets, at least for now, but it also highlights the level of imbalances in Europe. The fact that this rescue package took the better part of four months to construct underscores that the monetary and fiscal institutions in the euro-zone are not conducive to a single currency. The euro bailout is the product of what a federal government could construct in days. The austerity measures that will accompany the program at the hands of the IMF and a politically reticent Germany will do little more than choke off growth and fuel political discontent in Greece. While that may make investors happy for now, faith will quickly shake when protests rock reforms or stagnant numbers surface among the PIIGS.

The level of the required bailout should raise more concerns than it ameliorates, as investors look around at where risk is held. The popular recent analogy to U.S. toxic assets is not a perfect one, especially as the euro-zone has fewer institutions capable of stepping in to calm markets. At the end of the day, Europe has put its currency union ahead of its political union. Until Europeans are willing to cede greater autonomy to a federalized body (a development as likely as the formation of an EU soccer team), this process of fear and bailout is doomed to repeat itself. The question is whether the next of the PIIGS to follow Greece to the slaughter will be too-big-to-save.

From the way markets reacted, the trillion-dollar rescue package hurled by European leaders at the continent’s growing debt crisis might well have been code-named Panacea. Stocks rose all over the place while Greek bond yields tumbled on Monday. But this is far from the end of the story. The rescue package alleviated the growing Eurozone liquidity crisis, but the solvency crisis remains. While the acute problem (liquidity) was a serious threat, so is the chronic problem of excessive indebtedness that besets Greece, Portugal, Spain and Ireland.

The rescue plan cannot address the central problem, which is that countries with very different fiscal cultures (and earnings potential) are yoked to the same currency. The idea was that this would help the profligate keep in line, but instead it’s shaping up as a way for them to ship their liabilities to their fitter neighbors. How long will voters in rich countries stand for this? Perhaps not much longer than the voters in the debtor countries will stand for the austerity measures imposed on them.

The entire rescue plan presumably rests on the assumption that, with more time, the Eurozone’s problem countries can get their fiscal houses in order—and Europe can somehow grow its way out of trouble. But Greece and some of the other major European debtors are seriously uncompetitive. And the medicine of austerity may not work, if only because the patient may refuse to take it.

The countries in question are democracies, after all, and it is far from certain that Greece and the others will cut spending and raise revenue enough to make a difference. Austerity means stagnant wages; in Greece, public sector paychecks are supposed to shrink 10% along with pensions cuts and increases in the retirement age. But April inflation in Greece was the highest in the Eurozone — a rate of 4.8%. Higher taxes will continue to make life more expensive for people earning less money. It’s a volatile mix.

What is missing is a policy mechanism that provides a way to even out trade imbalances by recycling the surplus of counties such as Germany, Netherlands and France to the deficit countries for pro-growth direct investment. Germany did this with East Germany. If it can be accomplished, it’s one way Greece and the others can become competitive enough to secure their future through higher exports. This is in concert with the same adjustment mechanism that many Levy Institute Strategic Analysis reports (see for instance this one) have been suggesting for many years at the global level with regard to China in solving the problem of global imbalances.

It’s hard to see a positive European outcome from the rescue plan, given the perverse incentives in place. Higher taxes in Greece will only mean more tax evasion (see Gennaro Zezza’s insightful post on this). The bailout will only make it harder to convince people in Greece, Portugal and the other problem debtor nations that failing to change will result in disaster. Since the real rescue is of European banks that hold all this debt, we have once again a transfer of money from thrifty taxpayers to imprudent banks, making moral hazard more hazardous.

The markets may not like to hear it, but sooner or later Greece will have to restructure its debt; one or more of the others will probably have to do the same. Their structural primary deficits are simply too large to come into balance with all the deflationary austerity measures. Growth, in these countries, will be negative at least for the next two years after the current year. Meanwhile, the smart money is headed for the exits.

I’m Italian, and I’m an economist, so as European leaders work feverishly to save the Euro, I’ve been wondering: what would happen if the feared contagion occured and my own country saw its finances melt down just as Greece’s have? The short answer is that this would generate a fatal shock to the Euro, given the size of Italian public debt and the fact that a large share is owned by other Euro countries.

Of course, such an event is by no means a foregone conclusion. But I can’t help noticing an ominous correlation. The country in Europe with the biggest untaxed, or “shadow,” economy as a proportion of GDP is Greece. Next is (gulp) Italy. Then Portugal and Spain. On the chart below, in fact, the bars look unsettlingly like dominoes.

Much of the problem in these countries in Europe, in other words, is tax evasion. As the chart shows, the size of the shadow economy in Italy and Greece is much larger than in other developed countries, inside and outside the Euro area.

Massive tax evasion helps produce large public-sector deficits. Let’s make some simple back-of-the-envelope calculations: if the shadow economy is adding 25 percent to GDP, with income going untaxed, and if the average tax rate on such income is a conservative 20 percent, recovering such tax revenues would imply an additional 5 percent of GDP in tax revenues, which would bring down the Italian 2009 deficit to zero. As deficits cumulate into debt, prolonged tax evasion could explain – by itself – the whole of the Italian public debt, now projected at 118.4 percent of GDP.

Attacking these deficits by raising taxes or freezing wages in countries where the shadow economy is so large could encourage further tax evasion, placing an ever-greater burden on an ever-shrinking proportion of law-abiding citizens who pay what they are asked. If Europe’s troubled public finances are ever to be set right, Greece, Italy and other nations with large underground economies must find a way to collect the taxes that now go unpaid.

(Figures in the chart are from F. Schneider, Shadow Economies and Corruption all over the World: New Estimates for 145 Countries)