Contagion fears in eurozone shouldn't bother the healthy

Greece sneezes and Portugal catches a cold. Portugal coughs and Spain falls ill. Spain runs a fever and Italy gets the flu.

Contagion, or contagion theory, is sweeping the eurozone, where Greece's debt crisis is infecting neighbouring countries and threatening to make its way across to the United States.

At least that's what we're told on a daily basis. European Central Bank council member Axel Weber warned last week of "grave contagion effects" for countries that have adopted the euro.

"Greece Fuels Fears of Contagion in the US," trumpeted a Wall Street Journal headline.

I hate to pour cold water on that theory, but healthy countries aren't susceptible to Greece's disease. The sick ones, already plagued with high debt levels and bloated state budgets, don't need a carrier. Capital flight from these countries "is not evidence of contagion", said economist and author Anna Schwartz.

Of course, Schwartz said that in 1998 after the Asian financial crisis. In International Financial Crises: Myths and Realities, Schwartz punctured the notion that financial crises spread from the initial source to innocent victims. Nations are vulnerable because of their "home-grown economic problems", she said.

Schwartz's insights are equally valid today. Capital isn't fleeing sovereign debt markets in Spain and Portugal because Greece can't pay its bills. Bond yields are rising because of an increased risk those countries may find themselves in the same boat as Greece: unable to pay their debts.

OK, maybe not quite as leaky a boat. It would be hard to match Greece's record of spending half the years since its independence in 1829 in default or rescheduling its debt, according to economists Carmen Reinhart and Ken Rogoff, authors of This Time is Different.

A single currency, it turns out, isn't a panacea for everything that ails Europe. The 11 nations that scrapped their sovereign currencies and adopted the euro in 1999 never constituted an optimum currency area as envisioned by economist and Nobel Laureate Robert Mundell, the father of the euro.

"They don't have a mechanism to deal with crises when they come up," says Michael Bordo, professor of economics at Rutgers University and author of a book on the history of monetary unions.

Europeans knew if they ceded domestic monetary policy to a centralised European Central Bank they would need "labour mobility and/or transfers from healthy states to weaker ones to deal with asymmetric shocks," he says.

Europe has neither. Political union is still a dream. Germans are still Germans, and Greeks are still Greeks.

Political union isn't a prerequisite for dealing with a sovereign debt crisis. What's needed is some kind of a priori agreement on how fiscal transfers are to be carried out, says William White, chairman of the Economic Development and Review Committee at the Organisation for Economic Co-operation and Development.

In the case of the euro zone, "they were short of a few fiscal elements", he says.

It's far from clear the German public would have supported such transfers from strong to weak countries, White says. Especially if it's the same profligate nations, such as Greece, that keep feeding at the trough.

That said, European leaders have invested too much political capital in a united Europe to turn back now. Germany's Parliament has approved a package of loans to Greece, part of a €110 billion ($196.9 billion) package from the International Monetary Fund and European Union. In exchange, Greece approved an austerity plan.

"This should be a wake-up call to design mechanisms to deal with crises and enforce the rules" on debt and deficits, Bordo says.

The 1992 Maastricht Treaty outlined four convergence criteria for joining the European Monetary Union, including a maximum deficit-to-GDP ratio of 3 per cent and debt-to-GDP of 60 per cent.

Last year Greece's deficit and debt were 13.6 per cent and 115 per cent, respectively, as a share of the economy.

All the infected countries, and a few that haven't caught the disease yet, are well over those limits. Britain's deficit last year was 11.5 per cent of GDP.

It would be a mistake to interpret the flight-to-quality into US Treasuries last week as a sign of immunity. The US is already infected with the debt virus. It's still in its incubation period.

- BLOOMBERG