The Greek bankruptcy (happened already with the debt restructuring), the ungovernability of the country sanctioned by the polls, and the prospect of exit from the Euro, evoke the specter of “contagion”. The fear shaking markets, governments as well as depositors, is that the precipitation of the Greek crisis will cause a crack on a continental scale: a scenario where a speculative attack against the sovereign debt of Portugal, Ireland, Spain and Italy, will force the messy default of these countries, and ignite a chain reaction of defaults in the European banking system, businesses, the collapse of production, mass unemployment in the EZ, the disintegration of the Euro, of the EU and of free trade in Europe. Argentina 2001 on an EU scale. How justified are these fears? My answer, in short, is “quite little.”
Contagion, literally, is “the transmission of an infectious disease by contact.” In a recent paper, two economists (Severgnini and Borner, 2011) use the historical archives of a large number of cities in Europe, North Africa and Asia Minor, to reconstruct, through the records of deaths, the path of the Black Death which struck and wiped off a third of the European population in the first half of the 14th century (1), see Figure 1. The epidemic, not surprisingly, spread along the routes of international trade, roads like the silkway, and the sea routes from the Mediterranean ports of Pisa, Genoa, Venice, Marseille.
The “epidemics” of today are partly different. On the one hand, just like the plague, they spread “by linkages” (eg: the exit of Greece from the Euro and ensuing devaluation of the drachma aggravate the problems of competitiveness and balance of trade in Spain and Portugal; French and German banks exposed to Greece suffer additional losses due to the forced conversion of their claims in the new currency). But the finance epidemics today spread mainly through “psychological effects”. The history of sovereign defaults in emerging markets, see Figure 2, involved both countries that were geographically and economically “neighbors” (in 1998, Russia, Ukraine and Moldova, Pakistan), and also countries with very few economic linkages (Russia and Brazil).
The past experiences of contagion teach us a couple of things. The first is that the diffusion by “contact” is not the most worrying thing. For sure, the dispersion of structured products issued by American banks among banks’ balance sheets around the world has contributed to exporting and magnifying the sub-prime crisis. Today, however, this channel of contagion from Greece is not very important: the losses of the banks of the peripheral countries, exposed to Greece for a total of about 465 billion, have already been realized, following the debt restructuring (and anyway, these banks need to be recapitalized, with or without Greece). A new Greek default would be paid mainly by international institutions (EU, EFSF, IMF), which now hold about two-thirds of the Greek debt, and therefore by taxpayers. The other “real” channel is devaluation. But a drachma depreciation would have a limited impact on the Euro zone, because the share of Greek exports in the EUZ is less than one percent.
The second lesson is that the “psychological” effects often take the following form: financial markets receive a “wake-up call”. They discover suddenly, perhaps after having culpably neglecting them, the structural vulnerability of economies at risk (see Bekaert et al. 2011). They find that, for example, Spain, Portugal and Greece have reduced their competitiveness relative to Germany by 30-40 percent between 2000 and 20008, that the Greek debt is unsustainable, that the outbreak of the real estate bubble has taken a heavy toll on Spanish rural banks, that years of failed reforms in Italy (and Portugal), combined with lax policies, have brought the Italian debt to the GDP ratio to where it was in 1996, when interest rates were close to 10 percent. Markets do not go crazy all of the sudden, they rediscover, perhaps with a temporary overshooting, the importance of longly neglected fundamentals (see Manasse, 2012). Whether or not Greece remains in the Euro, the Greek contagion can be avoided. This requires peripheral countries to put in place the necessary adjustment policies without killing the chances of recovery, and Germany to abandon the obsession with fiscal rigor, to return to being the locomotive of Europe.