Market Contagion

February 9, 2010

Although Greece constitutes just 2.65% of the euro area economy, it is understandable why the Greek debt crisis rattled the region’s other markets.  One element of Greece’s problems, the unreliability of reported data and past gimmicks used by Greek authorities to meet standards for joining the European Monetary Union, naturally raise suspicions about other members with either large public sector deficits or excessive accumulated debt or both.  Among such countries, Portugal, Ireland, and Belgium have only a combined 7.4% share of Euroland GDP, but Spain and Italy comprise 28.7% of the pie.  Even if a credible plan with outside support is devised to consolidate Greek public finances, the other questionable pieces of common currency union add up to a decently sized slice. 

From the outset, the euro was destined to be a watered-down version of the Deutschemark even if the European Central Bank adopted the identical orientation of the German Bundesbank, stressing long-term price stability and a currency that holds its value in external as well as internal terms.  Currency values embody a broader range of economic parameters than monetary policy, so tying the mark to other European currencies that because of a variety of structural shortcomings that in decades past had depreciated against the mark was bound to produce a hybrid that would not perform quite as well. In period-average terms, the dollar had declined against the mark by 34.3% in the 1970s, 14.7% in the 1980s and 27.0% in the 1990s, but it rose 0.4% in the noughties against the euro.

At first glance, it seems less obvious that the strains in Greek markets should impair the performance of U.S. and other non-European financial markets.  Greek equities are down around 10% since January 19, but that market’s drop doesn’t dwarf declines of 8.2% in the Dax, over 7% in the Ftse, Nasdaq and Nikkei, and 6-7% in the Dow and S&P 500.  One explanation for such contagion is that Euroland’s combined budget deficit last year of roughly 6.3% of GDP was actually smaller than comparable ratios of more than 7% in Japan, about 10%-plus in the United States and Britain.  Likewise, Euroland had a 2009 current account deficit of less than 1% of GDP, which was significantly smaller than the external gaps of the United States and Britain.

Another explanation is that in the era of commercial, financial and informational globalization, market contagion similarly knows few boundaries.  A lesson of the Great Recession was that diversification, both across different asset classes and different countries, provided less protection than assumed.  Broad contagion has become a fact of life.

The sensitivity of stocks in North America and Asia to news from Greece also suggests that investors were looking for any excuse to bail out.  For a period exceeding ten months, the U.S. Nasdaq, S&P 500 and Dow Jones Industrials had risen by annualized rates of 100.8%, 84.5%, and 76.8%.  Who at the start of March 2009, when pessimists were projecting a rise in unemployment to 8%, not 10%, imagined such a powerful and uninterrupted bull market that didn’t jive with the fragile, uneven and uncertain nature of the transition to economic recovery?  Today’s been a good day for equities because rumors are swirling that aid for Greece from other Europeans will be soon announced.  I hope I’m wrong but doubt that will provide a sustaining cap for the downward correction of equities that was overdue.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



Comments are closed.