Can there be contagion with the Greek cri­sis?

Financial Mirror (Cyprus) - - FRONT PAGE -

One ques­tion that has been hov­er­ing for some time, but has re­mained unan­swered, is what will be the likely out­come of a “Grexit” to the rest of the Eu­ro­zone coun­tries as well as the rest of the world. Will there be a contagion ef­fect to other Eu­ro­zone mem­bers as well as other parts of the world? This is a hy­po­thet­i­cal but also dif­fi­cult ques­tion to an­swer. On the one hand, the Ger­mans are ar­gu­ing that now (un­like ear­lier years) the Eu­ro­zone is shielded against any pos­si­ble “Grexit”, with the in­tro­duc­tion of the Euro­pean Sta­bil­ity Mech­a­nism (ESM) as well as the bank­ing union. On the other hand, oth­ers ar­gue (in­clud­ing my­self) that such an out­come will be hard to con­tain and will ex­ert tremen­dous pres­sure on the Eu­ro­zone mem­ber states (as well as other, un­re­lated parts of the world). Eco­nomic his­to­rian Barry Eichen­green at the Uni­ver­sity of Cal­i­for­nia at Berke­ley re­cently warned that if Greece leaves the euro, “in the short run, it would be Lehman Broth­ers squared”. Thus, we need o un­der­stand how such a cri­sis can be prop­a­gated to other coun­tries or re­gions of the world.

Be­fore look­ing at the chan­nels of prop­a­ga­tion, let’s first de­fine what we mean by “contagion”. This is the trans­mis­sion (or spillover) of a fi­nan­cial shock from one econ­omy to an­other, and we have a num­ber of such ex­am­ples in re­cent his­tory – the Mex­i­can cri­sis in 1994 (“tequila cri­sis”), the East Asian cri­sis in 1997 (“Asian flu”), the Rus­sian de­fault in 1998 (“Rus­sian virus”), and, last but not least, the “Great Re­ces­sion” of 20072009 that orig­i­nated from the US and prop­a­gated to other re­gions of the world.

A num­ber of mod­els (or mech­a­nisms) have been de­vel­oped and tested that ex­plain how a fi­nan­cial (eco­nomic) shock can be trans­mit­ted. Some of th­ese are ra­tio­nal, oth­ers are ir­ra­tional. Be­low are some of th­ese the­o­ries:

1. Fun­da­men­tal link­ages – coun­tries af­fected face sim­i­lar prob­lems and fur­ther­more they are in­ter­con­nected through trade and cap­i­tal flow link­ages.

2. Asym­met­ric in­for­ma­tion – in­vestors and mar­ket par­tic­i­pants might have in­com­plete or asym­met­ric (some know more than oth­ers) in­for­ma­tion about the un­der­ly­ing rea­sons why a cer­tain cri­sis oc­curs, and leads them to take cer­tain ac­tions, such as with­drawal from other coun­tries or re­gions of the globe fear­ing that th­ese economies might face sim­i­lar prob­lems.

3. Port­fo­lio re­bal­anc­ing – af­ter an ini­tial shock in one mar­ket, in­vestors re­assess the risk of their port­fo­lio and re­bal­ance it which could lead to ex­it­ing from other re­lated, or even un­re­lated mar­kets.

4. Cor­re­lated liq­uid­ity shocks – fol­low­ing the ini­tial shock in one mar­ket can lead to de­creased lev­els of liq­uid­ity in sev­eral oth­ers, i.e. “dry­ing up” of liq­uid­ity.

5. Herd­ing chan­nel – an ir­ra­tional model where in­vestors fol­low the “herd”, or mimic the ac­tions of oth­ers lead­ing to a big­ger cri­sis.

A num­ber (if not all) of the above chan­nels of prop­a­ga­tion of a cri­sis could be at work, in case of a Greek exit from the Eu­ro­zone. First, there are coun­tries in the Eu­ro­zone that face sim­i­lar prob­lems (although not to the same ex­tent) with Greece (e.g. Italy). Fur­ther­more, surely there ex­ists trade and cap­i­tal flow link­ages be­tween Eu­ro­zone mem­ber coun­tries.

In terms of the asym­met­ric in­for­ma­tion chan­nel, af­ter a “Grexit” in­vestors would start fear­ing that such an event could also oc­cur in other coun­tries in the Euro area. This could lead to sharp de­val­u­a­tions of the euro, bank runs, cap­i­tal re­stric­tions, and large in­creases in sovereign spreads, even for coun­tries that are con­sid­ered to have strong economies (e.g. Ger­many). The same ef­fect could hap­pen be­cause of re­bal­anc­ing of port­fo­lios, cor­re­lated liq­uid­ity shocks, or be­cause of herd­ing be­hav­iour. This could shock not just Euro­pean mar­kets and economies, but other, un­re­lated re­gions of the globe (Asian or North Amer­i­can mar­kets).

Thus, it is to the best in­ter­est of ev­ery­one for Greece to re­main in the Eu­ro­zone (and the EU) even if both sides (Greece vs. its lenders) have to make big com­pro­mises on their ini­tial po­si­tions. As the newly-ap­pointed Greek Fi­nance Min­is­ter Ya­nis Varo­ufakis has stated re­cently on BBC about the euro, “you can check out any­time you like, but you can never leave!”

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