Greek debt crisis begets euro crisis. How much is it fear driven?

Here’s a question that economic historians will ponder soon enough: Which came first during the Greek debt crisis of 2010 – the fear of contagion in global markets or the contagion itself?

The answer could help prevent the domino effects of another financial knockdown in the future. As it is, leaders in European Union (EU) are still trying to figure out how to slow the tsunami-style damage to stock markets from Greece having come close to not paying its debts because of overspending.

“It’s absolutely essential to contain the bush fire in Greece so that it will not become a forest fire,” said Olli Rehn, European monetary affairs commissioner.

A $140 billion, three-year rescue plan for Greece may be only the first step in preventing other fiscal weaklings in the 16-nation eurozone, such as Portugal, from going the same route as Athens in being forced into sudden austerity. Leaders often must stem investor fears by pouring more and more money into shattered markets to restore certainty and credibility.

The term contagion has been thrown around so loosely since Greece’s debt woes became known that its use may have helped make it more of a reality. In fact, economists who study the viral effects of financial woes have a phrase – “pure contagion.” It describes a situation in which a crisis triggered in one country appears unwarranted because the economy’s fundamentals are still sound. (A better term might be Chicken Little contagion – or that fear begets fear – when the sky isn’t really falling.)

There remains very little consensus among economists on how to define contagion or how to explain the ricochet of fear in markets. Yet, as the world’s countries have become more interdependent, so, too, have the number and intensity of global financial panics, such as the Mexican crisis of 1994-95, the Asian crisis of 1997, the Russian crisis of 1998, and the Wall Street crisis of 2008-2009.

It is becoming ever more imperative to sort out the fear of financial shock waves from the actual shocks. Otherwise, many countries will start to close their borders to trade, capital flows, and even new technology in hopes of safeguarding themselves from global or regional crises.

Many countries envy India and China in their apparent ability to suffer little from global shocks by insulating their domestic markets. (Their markets are so big, however, they can afford to block many foreign competitors.)

The rapid pace of economic interdependence has far outpaced the slow growth of global regulations. Nations are reluctant to give up sovereignty even as they expose their economies to world trade – and to speculators who play on investor fears.

Like past global crises, the one that started in Greece needs to be studied to see which fears were worthy of a solution and which fears are built on fear itself.