Sunday’s edition of The New York Times carried an excellent analysis of the global threat posed by the Greek debt crisis. Nelson Schwartz and Eric Dash explained that the potential for Greece to default on its debt obligations is still there. Furthermore, the risk this poses is shared across the global economy. Volatility has returned on global markets to such an extent that the recovery beginning to take hold in many countries is in jeopardy.

“What was once a local worry about the debt burden of one of Europe’s smallest economies has quickly gone global,” wrote Schwartz and Dash. “Already, jittery investors have forced Brazil to scale back bond sales as interest rates soared and caused currencies in Asia like the Korean won to weaken. Ten companies around the world that had planned to issue stock delayed their offerings, the most in a single week since October 2008.”

This is contagion. Investopedia defines it as “the likelihood of significant economic changes in one country spreading to other countries.” Those changes can be positive or negative. The world’s economy is more connected than ever before, so when a country like Greece gets into difficulty, it is not simply a European problem. It is, at least potentially, a global problem.

What do we know about contagion, and how can it help us understand what’s happening in Greece? Despite the fact that economic contagions are a relatively new phenomenon – their study didn’t become popular until after a series of financial crises in the 1990s – we do understand its fundamentals. Sergio Schmukler and Marina Halac of the World Bank and Pablo Zoido of Stanford University collaborated on a useful paper entitled Financial Globalization, Crises, and Contagion.

A few highlights:

• Trade between countries is not new. What’s changed is the extent to which the world’s nations, corporations and investors are linked to one another. That began happening in the 1970s. “Decreasing capital controls and increasing capital mobility with a growing participation of a wide range of developing countries in the global financial system characterized the post-Bretton Woods era, leading to a more integrated world economy towards the 1990s,” they wrote.
• Governments, borrowers, investors and financial institutions have all played a part in financial globalization. Governments have removed restrictions on their domestic financial services sectors. Organizations and individual investors have taken advantage of opportunities to participate in global markets. Global investment, in both developed and emerging markets, has never been easier. That’s in part due to advances in information technology.
• Access to global markets provides a range of benefits, including economic development. There are consequences though. “Financial globalization can lead to crises in countries with weak fundamentals as the economies become subject to the reaction of domestic and foreign investors,” wrote Schmukler, Zoido and Halac. “Globalization can also lead to crises in countries with sound fundamentals. Imperfections in international financial markets and external factors that determine capital flows make open economies more prone to crises. Furthermore, countries that integrate into world financial markets become exposed to contagion. Crises can spillover to other countries through real links, financial links, or capital market imperfections such as herding behavior or panics.”
• Herding behaviour is an important concept. Many investors lack access to all the information they need, so they follow what the majority of other investors are doing. This enhances investor reaction to an event or series of events, and can lead in some cases to outright panic. “If markets regard a country’s state to be good, then large capital inflows can take place. If markets judge the country as being in a bad state, then rapid capital outflows and a crisis can take place,” they wrote. “When investors observe a crisis in Thailand, they react to it thinking about a potential crisis in Indonesia and Malaysia, and a crisis indeed takes place. Both developed and developing countries markets are subject to these panics. Because investors know little about developing countries, they are probably more prone to herding behaviour in these markets.”
• On balance, financial globalization is a good (arguably inevitable) thing. But it has made management of an individual country’s finances more complex. “Even with the larger exposure to crises and contagion, the evidence suggests that the net effects of financial globalization are still positive, at least in the long run,” wrote Schmukler, Zoido and Halac. “The main challenge for policy makers is therefore to manage the integration process as to take full advantage of the opportunities, while minimizing its risks. This task is not easy, particularly because financial globalization influences the instruments available to policymakers. In a more integrated world, governments are left with fewer policy tools and thus international financial coordination becomes more important.”

Early today, in an attempt to get out ahead of the still-developing crisis, European Union finance ministers agreed to a continent-wide relief package valued at nearly $1 trillion. The International Monetary Fund will contribute some of that amount. The Financial Times called it “audacious,” reporting that the deal includes government-secured loans and a promise to buy European government bonds.

Whether that will do the trick remains to be seen. Markets around the world rose sharply this morning.

Schwartz and Dash quoted William H. Gross, managing director of the famous bond management firm Pimco, who put the Greek threat in bleak terms. “Up until last week there was this confidence that nothing could upset the apple cart as long as the economy and jobs growth was positive,” he said. “Now, fear is back in play.”