Monday, May 23, 2011

Thinking about Contagion in Europe

Greece has been hogging all of the stories regarding the euro-zone debt crisis, but this morning Alphaville notes that there have been some wider tremors in European financial markets in recent days. The Dread Pirate Contagion is threatening to set sail and once again terrorize the high seas.

How likely is the crisis to spread in a meaningful way to Spain or Italy? That is, of course, one of the most important questions we can ask about this entire mess, because if investors lose confidence in the debt issued by those governments in any serious way, then Greece, Ireland, and Portugal will seem like mere footnotes by comparison.

In order to get a feel for how likely contagion is in this situation, it's helpful to carefully think through the possible mechanisms by which the crisis could spread to Spain and Italy. And I think it makes sense to think about two different categories of transmission mechanisms: "spillover effects", and what I will call true "contagion".

Spillover Effects: I think of spillovers as situations in which events in one country affect the underlying macroeconomic fundamentals of another country. In other words, a financial crisis in Country A may affect the “real” economy of Country B, for example by a fall in exports from B to A. The negative impact on Country B's economy could then make it harder to support a given exchange rate or debt burden, causing a financial crisis in Country B.

Contagion: By contrast, what I think of as true "contagion" is a situation in which events in Country A cause a speculative attack or crisis in Country B even though the macroeconomic fundamentals in that country have not changed and may not otherwise warrant concern. I think that this matches the situation in Europe right now, because the concern is not that events in Greece will have a significant impact on Spain's GDP or tax revenues; rather the concern is that events in Greece will spark a sudden change in the market demand for Spanish financial assets (which may then in turn impact the real economy of Spain, of course).

What could cause the crisis to spread to Spain or Italy? More generally, why does true contagion happen, so that when Country A has a financial crisis, it sometimes (though certainly not always) spreads to nearby Country B? Here are a few mechanisms that have been explored in the literature:
  • A common external shock: whatever initially triggered the crisis in Country A also impacts Country B, and may therefore start a crisis in Country B for the same reasons.
  • The “wake up call”: the crisis in Country A makes investors take a closer, more critical look at their portfolio, and thus makes them more likely to dump all assets of countries even remotely similar to Country A just to be on the safe side.
  • Information cascades/herding behavior: investors look at the behavior of other investors to gather information, and specifically to get clues about how risky a particular class of assets might be. So once a few people start heading for the exits everyone follows in a rush.
  • Liquidity concerns among common creditors: when creditors expect losses in part of their portfolio due to a financial crisis in Country A, they may become forced to quickly sell of other parts of their portfolio -- including assets from Country B -- in order to maintain sufficient liquidity.
  • Cross-market hedging among common creditors: when creditors see the riskiness of part of their portfolio rise due to a financial crisis in Country A, they try to balance that out by decreasing the overall riskiness of the rest of their portfolio, so they sell assets from any countries not seen as safe havens.
In the case of Greece and Spain, however, I feel like I could make a pretty good argument against each of these possible mechanisms, particularly given the way that the Greek crisis has been unfolding relatively slowly for over a year now. I won't go into each of my counterarguments right now (maybe later), but suffice it to say that none of these possibilities convinces me that we should expect a Greek default to translate into a sudden sell-off of Spanish government bonds.

It bears much more thinking about... but for now, and despite my conviction that events in Greece are going to end with default and a Greek exit from the euro-zone, I'm oddly optimistic about Spain and Italy. I simply haven't heard a convincing reason for why we should expect Greek default to be contagious. I'm very open to suggestions, though, so feel free to try to persuade me otherwise...

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