Can there be contagion with the Greek crisis?
One question that has hovered around the global media recently, but has remained I believe 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, i.e. will there be a “contagion” effect to other Eurozone members as well as other parts of the world? This is obviously a hypothetical but also difficult question to answer. On the one hand, the Germans are arguing that now (unlike earlier years) the Eurozone is now 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 are arguing (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 globe). Famous economic historian Barry Eichengreen at the University of California at Berkeley has recently warned that if Greece leaves the euro: “In the short run, it would be Lehman Brothers squared”. Thus, the purpose of this short article is to explain how such a crisis can be propagated to other countries or regions of the world.
Definition of contagion
Before looking 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 others, 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 2007-2009 that originated from the US and propagated to other regions of the world.
Methods of transmission
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 it can lead to decreased levels of liquidity in several other markets, 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.
The case of the Greek crisis
I believe that 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 area 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 happen also to other countries in the Eurozone 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 behavior. 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 area (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 has stated recently on BBC about the euro, “you can check out anytime you like, but you can never leave!”
Find more: Contributing Authors
The Greek exit will not only have a contagious effect on other EU countries, but regrettably will wound irrevocably the essence of the European Unity, of the political idea of European nations standing for each other and supporting each other.
Grexit will be the Russia’s bonanza because the winds of division will blow in EU. The only thing that has been preventing Putin from fulfilling his ambitions of restoring Russia to its destiny was the EYROPEAN UNITY, once that Unity starts to crumble, and will certainly crumble nothing will stop Putin’s plans for European dominance.