Contagion in Three Forms Has Grip on Europe: Simon Johnson

http://www.bloomberg.com/news/2011-07-17/contagion-in-three-forms-now-has-grip-on-europe-simon-johnson.html?cmpid=

There are three types of contagion in a financial crisis, when the potential collapse of a firm, bank or country threatens to spiral out of control. The European Union today has all three.

The first type is purely psychological -- the panic of herd behavior. The second comes from thinking through the real effects that a collapse would have, as the potential spillovers dawn on people. The third, and most devastating, emerges when smart investors realize that their assumptions -- based on the pronouncements of policy makers -- are all wrong and need to be tossed overboard.

A common characteristic of the panic phase is that the bottom drops out of economic forecasts, taking
with them the perceived ability of companies or countries to pay their debts. The corollary of this is that estimates of losses soar to once-unimagined levels. Some analysts now suggest that Greece might have to impose a haircut -- or loss -- of as much as 80 percent on creditors. This is up dramatically from the recent market view that 40 percent losses might be needed in a restructuring.

Emotions are taking over and the abyss looks bottomless, as it did for Russia in 1998 or Argentina in 2002. Countries, unlike companies, don’t go out of business. But in its panic, the herd tends to forget that.