Don’t Fear the Grexit

The news Wednesday that European Union finance ministers may be preparing contingency plans for a Greek exit from the eurozone sparked a fresh round of commentary about global financial turmoil in which financial writers interpreted perfectly ordinary market performance in the United States as a “selloff” triggered by the Greek crisis.

Renowned commentators are also ringing the alarm bells. New York Times columnist Paul Krugman recently predicted that “[t]hings could fall apart with stunning speed, in a matter of months, not years. And the costs — both economic and, arguably even more important, political — could be huge.” The developments in Greece even have some commentators invoking the spectacular collapse of Lehman Brothers, which touched off the greatest global financial crisis and economic depression since the 1930s, and has called into question the resilience of global governance institutions. Over at the Financial Times, Martin Wolf argues that the “danger of contagion” from a Greek departure “is obvious,” that “the risk that a bigger eurozone upheaval would cause a global crisis is real,” and that the fallout “would be worse than [the aftermath of] Lehman Brothers’ failure in 2008.”

Can we all take a deep breath now?

Our research on global financial networks indicates that these concerns are overstated. Further economic and financial deterioration in Greece would certainly have negative impacts there and might adversely affect Greece’s southern European neighbors, who are facing similar circumstances. But financial weakness in Greece is unlikely to spark a global crisis analogous to the one triggered by Lehman Brothers’ collapse in September 2008 — even if economic woes eventually force Greece to exit the monetary union. Instead, the global consequences of southern Europe’s debt crisis are more likely to resemble the Latin American sovereign debt crises of the early 1980s, the East Asian crises of 1997-1998, and Argentina’s crisis at the turn of the millennium. Each of these had significant local effects — widespread bank failures, sharp increases in unemployment, large exchange-rate devaluations, deep recessions — that were not transmitted globally. Indeed, in each of these cases the global economy continued to grow (see the graph below), major world equity markets held their value, and world trade expanded. None had the dramatic global consequences sparked by Lehman’s collapse.

As the graph below demonstrates, the recent subprime mortgage crisis, which hit the center of the financial system, took a far greater toll on the global economy than the peripheral crises that struck East Asia and Argentina and primarily inflicted regional damage.

To understand why the global fallout from the Greek crisis is more likely to resemble Argentina than Lehman Brothers, let’s remember what financial contagion is and how it spreads through the global financial system. Contagion occurs when an asset’s value declines so much that banks and other financial institutions that own it are rendered insolvent. Insolvent banks cannot meet their obligations to their partners, which drives these “counterparties,” as they’re known in the finance world, toward insolvency as well. This is what happened with Lehman Brothers: Its mortgage-backed securities holdings lost so much value that the bank could not cover the debt it owed to the financial firms from whom they had borrowed. The resulting loss of capital in those firms weakened their balance sheets. This cascade of weakness through financial networks was aggravated by uncertainty about who owed what to whom and the consequent inability to evaluate the risk of transactions with any financial institution. As a result, interbank lending and short-term credit markets froze. This is how contagion spreads throughout the dense web of connections that make up global financial markets.

Because these global financial network connections have strengthened dramatically over the past several decades, there is now widespread concern that a crisis that hits anywhere can lead to instability everywhere. What’s often overlooked is that how countries are connected — not just where within the network a crisis originates — has a dramatic impact on whether a local crisis sparks a global crisis. Lehman Brothers had a dramatic global impact because Lehman operated at the center of the U.S. financial system — the world’s most connected market. Moreover, Lehman Brothers’ failure occurred as part of a broader systemic crisis: The five largest U.S. investment banks and hundreds of U.S. commercial banks were reorganized or disappeared and many non-bank institutions, such as mortgage lenders and hedge funds, collapsed. The systemic crisis in the United States spread globally because 80 percent of the countries in the world had placed assets in these institutions in an amount well in excess of their capital. Weakness in major American financial institutions translated directly into weakened balance sheets in financial institutions everywhere.

Greece, by contrast, is on the periphery of the global financial system. Few countries have a substantial share of their assets in Greek banks or Greek sovereign debt. U.S. banks, for example, had $5.8 billion in direct exposure to Greece at the end of 2011, roughly the same financial exposure that they had to Israel and a little more than half as much exposure as they had to Finland. In other words, the world hasn’t placed enough assets in Greece for default by the Greek government or the collapse of the Greek banking system to have far-reaching global repercussions. Some smaller firms that are less connected to the global financial system may suffer greatly from a Greek default. But these entities pose little threat to systemic stability, as we saw last year when the brokerage fund MF Global failed due to its exposure to European debt without triggering a broader crisis. For larger, more connected firms, exposure to Greece is such a small percentage of their overall asset portfolios that a Greek default is unlikely to cause insolvency. After all, JPMorganChase lost more than $2 billion on a side bet last week, but there was no threat of contagion. What’s more, major firms and their regulators have had years to prepare for the possibility of a Greek default, and Greece’s creditors have already discounted the value of the Greek debt they hold well below its face value (as much as 90 percent in some cases). There is not much left to lose.

What if a Greek default triggers defaults in Ireland, Portugal, and Spain? Here the situation would be more like the 1997 East Asian crisis, which had a significant impact on Indonesia, Malaysia, South Korea, and Thailand and a moderate impact on Hong Kong, Japan, Singapore, and the Philippines but was a temporary blip everywhere else. Since the crisis struck Asian countries on the periphery of the global economic and financial system, it mostly stayed in the periphery rather than infecting the rest of the world. Similarly, a crisis in Europe’s south will be felt most in Europe’s south, less intensely in Europe’s north, and very little in the rest of the world.

In short, Greece is not Lehman Brothers. Lehman’s failure triggered a global crisis because Lehman was at the center of the global financial network. Greece, in contrast, is at the periphery of this network. Global crises don’t start in the periphery. While a Greek collapse would certainly be devastating for Greece and some of its neighbors, the rest of the world is likely to escape with minor disruptions to their economies.