The social costs are in the end equal to the aggregate cost represented by the higher interest rates that the governments of all the other countries have to pay for their debt because of the fiscal irresponsibility of the original country. The difference between private and social costs implies a market inefficiency calling for some form of intervention whose objective is to internalise these kinds of externalities. In other words, the countries that pursue activities which risk causing contagion need to be constrained in pursuing such activities or “pay a price” which is proportional to the expected costs to the other countries which are affected by the contagion. This provides them with incentives to reduce the activities that could trigger contagion. Given that the possibility of contagion is well known from the literature and economic history, we should mind about both the preventive and corrective policies. In the case of sovereign contagion preventive policy options would include, fiscal rules and governance mechanisms that avoid excessive deficits or high stocks of public debt. Ex post policy options aimed at addressing the fall-out from sovereign contagion would include liquidity provision by central banks to financial markets, the recapitalisation of fragile banks and the swift implementation of growth enhancing structural policies and fiscal adjustment measures to regain market confidence in national economies and governments and offset the adverse effects of contagion. It goes without saying that – as a rule – prevention is by far preferable to addressing the problems that arise from contagion ex post.

6  Staff of the International Monetary Fund has found related evidence with different methodologies; see C. Caceres, V. Guzzo and M. Segoviano (2010), “Sovereign spreads: Global risk aversion, contagion or fundamentals”, IMF Working Paper, no. WP/10/120, May, or R. Arezeki, B. Candelona and N. Sy (2011), “Sovereign rating news and financial markets spillovers: Evidence from the European debt crisis”, IMF Working Paper, no. WP/11/68, March. See also G. Amisano and O. Tristani (2011), “The euro area sovereign crisis: Monitoring spillovers and contagion”, ECB Research Bulletin 14 (http://www.ecb.europa.eu/pub/pdf/ other/researchbulletin14en.pdf). BIS central bankers’ speeches  3  CDS premiums.7 Estimation proceeds in two stages, using multivariate frequency decomposition. First, each CDS series is decomposed into long-, medium-, and short-run shocks. Second, the long- and medium-run shocks of Greece, which are those that produce lasting effects, are used to explain the CDS spreads of another euro area country, while conditioning on the country’s own shocks. If the additional explanatory variables improve forecast accuracy over a 100-day horizon, the results from the model may be interpreted as an indication that developments in Greece are causing contagion. The results suggest that with the escalation of the sovereign crisis in July 2011, contagion from Greece has become a source of systemic risk for several euro area countries. Spillovers from the Greek sovereign crisis can explain the sharp deterioration in the perceived creditworthiness of the other countries under EU/IMF programmes, Ireland and Portugal that occurred in July 2011.