Euroland: The danger of contagion
* Despite strong efforts to turn sentiment in the Greek bond markets, all attempts so far have failed. The crisis dynamics we are seeing at the moment are following a concerning pattern that we have seen during other financial crises which got out of hand. The situation should therefore be taken very seriously.
* In this paper we look at the ‘standard crisis dynamics’ and use the pattern during the Asian crisis as an illustrative example of how a small regional crisis can end up with far larger effects for the global economy than initially thought possible.
* The Asian crisis was triggered by problems in the country in the worst state of affairs (Thailand) but quickly spread to other countries with similar problems and which shared the same story. Even South Korea – which was in a clearly better state – got sucked into the crisis through the negative spiral that ensued. This was a major surprise for policymakers at the time.
* Ultimately the Asian crisis spread to Russia and Brazil through complicated links in the global financial and economic system.
* A key lesson from the Asian crisis is thus that even countries that have decent fundamentals to begin with can get hit once the crisis dynamics set in.
* The danger of contagion is that panic can become self-fulfilling and very hard to turn once it gets beyond a certain point. In the current crisis, countries that look much better than Greece – such as Spain or Italy – could suddenly be in a crisis if bond yields rose to Greek levels. Given the size of these countries, it could become very critical and call for an unprecedented large-scale IMF rescue.
When falling prices lead to falling demand
The contagion we are seeing at the moment to other Euroland countries should be taken very seriously. We start to see the dangerous crisis dynamics in which falling prices do not lead to rising demand but rather the opposite. This can create a toxic negative spiral in which the decline in bond prices scares more people and leads them to see less value in holding the bonds rather than more value even though the bond as such has become cheaper. A bank-run mentality of „better safe than sorry‟ is leading to selling in markets which, in a normal situation, would cope well but in the current environment could get hit. Evaluating bonds from a rational or fundamental perspective is dangerous in this environment as fear takes over and „irrational selling‟ becomes the main driver.