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Why Greece won't trigger a global crisis

Spencer KimballJuly 7, 2015

Limited private sector exposure and massive public sector intervention means little risk of financial contagion spreading from Greece. But there is one area of uncertainty: European politics, says DW's Spencer Kimball.

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Image: picture-alliance/dpa/F. Gambarini

Financial contagion is normally preceded by a surprise.

Take the 2008 Wall Street meltdown as an example. The US housing market had experienced a boom. Seeking to profit from the bonanza, private financial institutions the world over purchased securities issued by the mortgage lenders Fannie Mae and Freddie Mac.

Fannie and Freddie are government-sponsored enterprises. As a consequence, investors implicitly assumed that securities issued by the two mortgage lenders were backed by Uncle Sam. But their assumption was wrong, at least initially.

Fannie and Freddie's securities did not have the same backing as US Treasury bills and when the boom went bust, financial institutions were exposed to more risk than they had anticipated. As the crisis spread through the US and global financial systems, the federal government was ultimately forced to intervene and bail out Fannie and Freddie.

"Financial institutions had wildly underestimated the riskiness of these assets, which made for really fast and furious contagion," Carmen Reinhart, an economist who researches financial contagion at Harvard's Kennedy School of Government, told DW.

No more surprises

Greece, on the other hand, has been gripped by a sovereign-debt crisis since 2010, and the private sector has had ample opportunity to reduce its exposure over the past five years.

"The more time you see that a country is being downgraded, that the assessment points to a higher probability of default, you have time to unwind that exposure," Reinhart said. "That's essentially what has happened since 2010."

Meanwhile, the public sector has expanded its role in financial markets since the 2008 crisis, reducing the risk of contagion.

"There's been almost an overreaction to 2008 in terms of intervention by central banks and governments and the tightening of the safety net," Michael Bordo, an economic historian at Rutgers University, told DW. "We're not going to have a repeat of 2008."

Limited exposure

The private sector now holds just 17 percent of Greece's debt, according to Bloomberg. The International Monetary Fund, the European Central Bank and the European Union hold 80 percent of the country's debt. According to Reinhart, the distinction between private and public sector exposure is an important one.

When private financial institutions have too much leverage, their assets take a hit and they can no longer lend to their peers. Credit markets can freeze up as a result. But a public sector financial institution like the ECB operates on another level.

"The ECB can print euros that facilitates things just as the Bank of England or the Federal Reserve can print pounds or dollars to deal with a situation," Reinhart said. "The Central Bank of Greece cannot do that."

Which means Greece is essentially at the mercy of the ECB. On Monday, the ECB declined to increase its emergency assistance to Greece, making a default more likely. While a Greek default and possible exit from the eurozone would be devastating for the country's economy, it will have little impact on the ECB's ability to lend to other potential trouble spots, like Portugal.

The wildcard: European politics

So if there's little risk of European and global contagion, then why has Greece caused volatility on financial markets? According to Bordo, it's because European politics are often incoherent, which creates uncertainty.

"Because you're getting conflicting statements every day from the European authorities, people don't know what's really going to happen," he said. "It's not operating like a clean monetary union, like the United States or Canada."

It's still unclear how the financial markets will interpret the outcome of the Greek crisis. There's a possibility that markets will view a Grexit as a precursor to the unraveling of the eurozone.

"If that's how the markets perceive it, that could have negative effects," Bordo said. "The countries that are next on the list - Portugal is pretty small, Spain is not so small, and Italy is definitely not so small. That's the worst-case scenario."