Can there be contagion with the Greek crisis?

13 February, 2015 | Posted By: George Theocharides

By George Theocharides

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.

What is “contagion”?
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 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 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.

The case of the Greek 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 stated recently on BBC about the euro, “you can check out anytime you like, but you can never leave!”

The author is an Associate Professor of Finance at Cyprus International Institute of Management (CIIM) and the Director of the MSc in Financial Services