Is the Greek debt crisis spreading?

The challenge that Greece poses for investors is not its size. Its economy is a small fry on the world stage.

The challenge that Greece poses is that it's a domino.

It stands at the head of a long line of shaky, indebted economies. If political and economic leaders aren't careful, the Greek debt crisis could trigger a market panic that would push other heavily indebted countries into default.

Self-fulfilling prophecy?

Here's how the dominoes can fall: Spooked by the prospect of not getting their money back, investors who hold nations' debt demand higher interest rates to keep holding that debt. Higher rates make it even harder for indebted nations to pay down their debts, spooking more investors, who demand higher rates, and so on.

It's a self-fulfilling prophecy that could hit much bigger nations, including Spain, Britain, and perhaps even the United States.

In the past 24 hours, the world has gotten a foretaste of what a default wave might look like.

On Tuesday, when Standard & Poor's downgraded its rating of Greek bonds to junk status, it also downgraded its rating of the debt of Portugal, another highly indebted nation in the euro zone. Major European markets swooned. The Dow Jones Industrial Average lost 213 points, its biggest loos since Feb. 4.

On Wednesday, the wave of selling hit Asian markets, with Japan's Nikkei index losing 2.6 percent of its value. In midday trading, European stock indexes in the euro zone swooned again: nearly 1.5 percent in Germany; 2.3 percent in France. The Greek and Portuguese stock markets saw even bigger plunges over the last two days.

Meanwhile, interest rates on Greek 10-year bonds surged sharply to the equivalent of nearly 13 percent, about four times the rate for German borrowing. The premiums for insuring against defaults in Greece, Portugal, and Spain also rose to record levels.

Defaults are not inevitable

A wave of defaults is not inevitable. The European Union could quickly end the crisis by beefing up the bailout plan it has already approved, as Monitor guest blogger Stefan Karlsson has pointed out. Officials of the International Monetary Fund, the European Central Bank, and other international institutions were to meet Wednesday with Germany's Chancellor Angela Merkel and other officials to press for quick action.

The problem is that Germany and other EU nations would have to hold their nose to bail out fiscally imprudent Greece (reminiscent of how the White House and Congress had to hold their nose in 2008 to bail out fiscally imprudent but key financial institutions, such as AIG).

That solution is no big gift to the Greeks, either. Any deal would force their government to make massive cuts at a time when their economy is already shaky. (That would be like Congress cutting government spending last year instead of passing a fiscal stimulus, which would have made the great recession even more severe.)

The markets, however, may give the world's heavily indebted nations no choice in the matter.

If there is a silver lining in the crisis, it is that fiscal rectitude can set the stage for more sustainable economic growth.