Fear Contagion: Why The Fallout From a Grexit Will Be Impossible to Contain

Financial fear is incredibly contagious.

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Financial “contagion,” the process by which one bad event leads to a series of new bad events in the financial system, is key to understanding the stakes around Greece. That’s because Greece, on its own, is a pretty small country. Millions of people live there and what happens to them matters, but it wouldn’t be a big deal if not for contagion. And the thing about contagion is that it can come in two forms. Let’s call them “liquidity-based contagion” and “fear-based contagion.”

The way liquidity-based contagion works is that it can be the case that Jane is solvent only if Jack is solvent and Jack is solvent only if Jim is solvent and Jim is solvent only if Jill is solvent, so suddenly Jill’s unimportant-sounding bankruptcy can bring the whole house of cards crashing down. As a concrete example, back when the Tribune Company went bankrupt it came to pass that I wasn’t going to get paid a few hundred dollars that I was owed for a couple of LA Times pieces I’d done. That blew a small hole in my personal finances, but obviously it wasn’t that big a deal in the scheme of things. But if newspaper bankruptcies had blown a much larger hole in my finances I might have been unable to pay my mortgage. But when Bank of America gave me that loan, they inquired into my financial situation not the financial situation of the companies I did work for. These kind of lurking threats of debt cascades are always out there in the system to some extent, but at the same time it’s clearly possible to contain them.

Fear-based contagion is different. The way this works is that Jack owes you money and you feel fine about it, but then something about Jill welching on her debts to Jim changes your mind about the Jack situation so you suddenly demand your money back. This can be a pretty rational process. Like maybe Jill is a freelance journalist and so is Jack, and Jill’s bankruptcy makes you realize that people in that line of work have a more tenuous financial situation than you realize. But sometimes it can get a bit weird. The “tequila crisis” involving Mexican debt led to a contagion effect on Argentina. You can give some financial reasons for that tequila effect, but to understand it properly you need to apply the sociological point that in the minds of Americans the countries labeled “Mexico” and “Argentina” both go in the box labeled “Latin America” so “bad news about Mexico” can also be called “bad news about Latin America” which might mean “bad news about Argentina.” And at times other, even weirder, cultural constructs get made like “the BRICs” so that now somehow events in India are psychologically linked to events in Brazil.

What you’re hearing lately from the Powers That Be about the survivability of Greece leaving the eurozone is all about liquidity contagion. They’re saying that balance sheets are arranged such that the direct financial losses are survivable. But what about fear? It’s harder to assess, but anyone who’s sanguine about this is either bluffing optimistically or deluded. Ground zero for fear is going to be Cyprus. Most people probably don’t even know that Cyprus is an independent country at all, and if they do know anything about it what they know is that it’s some kind of ethnic Greek proxy state. So if Greece is gone, so is Cyprus, which is basically part of Greece. And if one island is gone, then what about Malta? So Malta’s down. Now Cyprus and Malta matter even less than Greece. But once the policy rule isn’t “Greece is different” but “Greece and Malta and Cyprus are all different” then who really knows. Does anyone even know anything about Portugal? Again, not really. Except it’s close to Spain! And so now Spain’s melting down. Not because of losses on Greek debt, but because the Greek exit and subsequent collapse of Cyprus have us new information about the limits of the German political class’ level of commitment to the eurozone and now everyone’s alarmed.

The only way to halt the pattern is to provide some very clear and very salient informational point separating the countries that are exiting from the countries that aren’t exiting. And that’s hard to do.