Contagion? What Contagion?

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 a 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 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 mediteranean
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), ando 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 greek (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 neglected 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.