Investor Confidence Fading Fast as Greek Debt Woes Drag On

There seems to be no end in sight to Greece's debt woes as Athens drags out its efforts to line up more funding. Investor patience with the fiddling, on the other hand, is quickly running out.

The Greek stock market sold off sharply Thursday amid soaring borrowing costs for the heavily indebted nation. Greece's borrowing costs rose to the highest level relative to similar German bonds since it entered the eurozone almost a decade ago. The cost of insuring Greek bonds, meanwhile, spiked to levels surpassing even those of beleaguered Iceland. And Greece's four largest banks scrambled for government support following a flood of withdrawals at the beginning of the year.

Greece's continued fumbling -- Greek officials continue to insist they can raise capital without assistance, brushing aside the skepticism expressed in the cold reception to the country's bonds -- weighed down world markets as well. Investors are reading the woes as a sign of things to come from other highly indebted European nations like Spain, Portugal and Italy.

Overreaction?

The market reaction to Greece's continued woes may ultimately be overdone, however. Greece's economy is a small player on the world stage and its continued stalling may have more do to with politicians avoiding unpopular austerity measures that will likely come with outsider assistance than with the chance of outright default. As European Central Bank President Jean-Claude Trichet declared, "a default is not an issue for Greece" despite the mounting pressures.

But once badly bitten investors are understandably twice shy. The story of big debt loads spiraling out of control despite reassurances that things were under control is awfully familiar to those who recently saw the subprime meltdown pronounced contained before it threw the world economy into a massive recession, or watched Lehman executives explain they had ample liquidity only to have the firm promptly file for bankruptcy.

Behavioral economists, who emphasize actual investor psychology beyond abstract models, like Yale's Robert Shiller, have explained that stories that resemble those that recently burned investors tend to be especially powerful. And given the impact of a financial crisis launched by large piles of low-quality debt, the tendency to shoot first and ask questions later is natural.

But investors need to be on the lookout for false alarms and keep things in perspective as well. A similar panic surrounding Dubai last winter was ultimately resolved more easily than many alarmed observers had anticipated at the time. And the commercial real estate market has yet to melt down despite persistent proclamations that it would crater much like the residential market.

Beware the Self-Fulfilling Prophecy

Still, a crisis of confidence can morph into a self-fulfilling prophecy, perhaps nowhere quicker than in the credit markets. Investor nervousness can overshadow the prospects of an outright default, and even undue panic leads to higher borrowing costs. That could well be the final straw for a European economy still teetering on the brink of another recession.

Among Greece's biggest fears, then, is fear itself. And the sight of Greek officials who seem oblivious to that and continue posturing should frighten investors as well.