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A Contagious Disease

May 6, 2010 • Economic Thinkers, Financial Markets, Government • 175 Views    No Comments

Seeing the Bloomberg Businessweek headline, “Greek Contagion Spurs Surge in Portugal, Spanish Debt Swaps,” I started thinking about diagnosing fiscal illness, treating it, and contagion.

How can we diagnose the illness? The illness seems to be the Greek spending disease. Just like you can identify a risky mortgage by looking at someone’s income, you can identify too much national (sovereign) debt by comparing it to the GDP of that country. As we noted on February 9th, for 2009, Portugal (75%), Italy (116%), Ireland (61%), Greece (108%), and Spain (57%) have debt that is too high a proportion of their national income.  

How do you treat a fiscal disease? Greece has moved to cut the wages and pensions of public employees and to increase sales taxes. In addition, articles abound about a tax system that needs to diminish fraud. Also, afraid of catching related illnesses, investors are inoculating themselves with credit default swaps. A credit default swap is insurance that relates to risky sovereign debt. In addition, could we say that healthier European nations and the IMF might give Greece a money IV? 

What is contagious? The contagion sounds rather similar to bank runs during the 1930s before the FDIC was created. Once one person became worried about a bank’s health, the concern spread with many rushing to withdraw their money. In today’s fiscal world, nations need to borrow. The contagion here is refusing to buy a nation’s debt.

Do you agree? Would you suggest another way to define the contagion? Other medical analogies?

The Economic Lesson

In his General Theory on Employment, Interest, and Money, British economist John Maynard Keynes said that nation should borrow during a recession. Then, by using the money to “prime the pump”, fiscal activism stimulates business expansion, the recession ends, government revenue surges, and the debt is repaid.

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