February 23, 2012
Since 2010, Eurozone countries have engaged in unprecedented rescue operations to avoid contagion from a potential Greek sovereign default. This column argues that news about Greek public finances does not affect Eurozone bank stock prices, while news about a Greek bailout does. This suggests that markets consider news about a Greek bailout to be a signal of Eurozone countries’ willingness to use public funds to combat the financial crisis.
In the course of 2010, the financial problems of Greece became so severe that the Eurozone countries together with the IMF agreed to provide emergency loans for a total amount of €110 billion, to be disbursed over the period May 2010 through June 2013. In addition, the European Financial Stability Facility was created, which issues bonds fully guaranteed by Eurozone countries and, after an enlargement in 2011, can provide up to €440 billion in financial support to distressed member states. Despite the no-bailout clause in the Maastricht Treaty, these extraordinary measures were deemed inevitable to reduce the risk of contagion. In particular, policymakers feared that since several banks had a high exposure to Greece, a restructuring of Greek debt would lead to a new banking crisis in the EU, and could destabilise other highly indebted Eurozone countries as well.
The threat of contagion from a Greek sovereign default is not undisputed. According to Cochrane (2010):
We’re told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn’t even any collateral to dispute or assets to seize. This isn’t new finance, it’s plain-vanilla sovereign debt, a game that has been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.With respect to a Greek default spilling over to other countries, Cochrane argues “[w]e’re told that a Greek default will lead to ‘contagion.’ The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won’t bail them out too. Any ‘contagion’ here is entirely self-inflicted. If everyone knew there wouldn’t be bailouts there would be no contagion.”
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