MADRID -- A third straight day of decline on world financial markets on Thursday was vivid evidence of a scary proposition: That the fiscal crisis that began in Greece months ago is spreading across Europe like a virus, causing growing doubt about the fates of even nations with far more manageable levels of government debt.

It is called the contagion effect, economists' metaphor for the rapid and hard-to-predict spread of a financial crisis, and it's driven by the fragility of investors' perceptions. Contagion is a function of vicious cycles in which confidence in a country's ability to repay its debts falls. If investors lose piles of money on the debt of one country, they assume that owning the debts of other countries with similar finances might cause them to lose them even more. So they sell their investment in the second country, which means that country has to pay higher and higher interest rates to get any loans, which adds to its debt and creates a fiscal death spiral that can well move on to the next country.

Spain is in the path of the storm and at the mercy of global investors, who are operating under the twin pressures of fear and greed. The country has less debt relative to the size of its economy than the United States or Britain, but contagion can threaten even countries that have managed their government debt responsibly if investors change their views about the country's future deficits or ability to handle debt.

The odds of a full-blown sovereign debt crisis have risen significantly over the past two weeks and especially after the market turmoil Thursday, such that Europe in 2010 looks increasingly like East Asia in 1997 and 1998, when a currency devaluation in Thailand sparked a broad crisis in Korea, Indonesia, and elsewhere.

Once a panic starts and contagion is spreading, it often takes dramatic government action to reverse the tide -- including external bailouts and steps to address the underlying cause of the crisis that are more aggressive than those needed in a non-panic situation.

In the case of Asia in the late 1990s, it took a wall of money from the International Monetary Fund and the United States to arrest the series of crises, combined with painful austerity measures in the nations involved. Banking panics have similar dynamics, and during the 2008-2009 financial crisis, the U.S. government stepped forward with the $700 billion Troubled Assets Relief Program, a series of unconventional lending programs from the Federal Reserve, and stress tests for major banks that required many of them to raise more private capital.

One lesson that could apply to the current situation is that a large-scale intervention from unaffected countries or the European Central Bank could ultimately be needed. Another is that government officials in the affected countries might need to promise more aggressive budget cuts than they would have if the situation hadn't become a market confidence game.

"You have to overdo the fiscal consolidation measures to convince people that you are serious," said Rodolfo G. Campos, an economist at IESE Business School in Madrid.

On Thursday, Jean-Claude Trichet, head of the European Central Bank, said there was no discussion at a bank policymaking meeting about buying countries' debt -- a decision that would mean essentially printing money to fund borrowing by Greece and other at-risk countries.

That drove up borrowing rates for Greece, Spain, Portugal, and other nations viewed as in financial trouble, and it drove the price of the euro down as low as $1.25 -- down from $1.27 Wednesday and $1.35 three weeks ago -- as investors betting on continuing economic turmoil in Europe shifted their money to dollars.

European stock markets fell, with the British market off 1.5 percent, France's down 2.2 percent, Spain's down 3 percent and Italy's off 4.3 percent. The Spanish stock market has dropped 11 percent since Monday.

Analysts had hoped the European Central Bank might use its essentially limitless ability to create money to stanch the crisis, though doing so could hurt the long-term credibility of the central bank as an inflation fighter that does not yield to politics.

"Measures that damage the fundamental principles of the currency union and the trust of the people would be mistaken and more expensive for the economy in the longer term," said Axel Weber, a member of the bank's policymaking council, according to Bloomberg News.

Still, Trichet did not explicitly rule out buying countries' debt, saying only that the concept was not discussed. This suggests that the idea is not out of the question if the situation becomes worse.

It did grow significantly worse since Trichet made his comments, with the European market sell-off followed by an even more dramatic decline -- and partial rebound -- in the United States.

The herd selling seen on both sides of the Atlantic is typical of financial contagion and shows how these crises feed on investor psychology, not just economic fundamentals.

In the case of Spain, the country's public debt only adds up to about 70 percent of its annual gross domestic product, compared with 84 percent in Germany, 82 percent in Britain, and 94 percent in the United States.

But with 20 percent unemployment and a generous set of social welfare benefits, Spain is running a higher annual budget deficit than those other countries -- 11 percent, compared with 2.3 percent in Germany. So to keep its debt from rising significantly, Spanish leaders need to rein in spending or raise taxes to reduce annual deficits.

Normally, they would have years in which to make that transition; after all, the debt wasn't going to explode overnight.

But since it became clear to global investors that Greece was more indebted than they realized and that the country may not be able to pay back what it owes, buyers of government bonds have been taking a hard look at countries with debt problems of their own. And they have focused on Spain, Portugal, Italy and Ireland.

Thus, while Spain may have more in common with Greece's sunny weather and nice beaches than its level of indebtedness, markets have turned on the nation.

"If you look like somebody who is sick, you get sick," Campos said.

Once borrowing rates rise -- Spanish 10-year bond yields have risen to 4.2 percent Thursday from 3.8 percent a month ago, though the shift in Greece was far more dramatic -- a vicious cycle is underway. With the price to roll over maturing debt higher, it becomes that much harder to trim the budget deficit.

The contrasts -- and increasingly, comparisons -- between Spain and Greece have become a fact of life for Spanish politicians and, increasingly, ordinary citizens.

On the streets of Madrid, citizens take umbrage at being compared to the Greeks, whose problems were caused by free spending and hiding their degree of indebtedness.

"No, Spain is not like Greece. Our mentality is completely different. We have a different mentality about working and developing things," said Juan Manuel Heranz, 35, a maintenance technician at the airport.

"We're not Greece," said Alexandra Gonzalez, 28. Her mother, Concepcion Lima, walking with her in downtown Madrid, chimed in: "But if we continue on like this, we will be."

 
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