Contagion can emerge quickly and often in unpredictable ways: The key lesson from the ERM crisis of 1992 and the Asian crisis of 1997

"The key lesson from the ERM crisis of 1992 and the Asian crisis of 1997 is that contagion can emerge quickly and often in unpredictable ways. Unwinding of leveraged positions by distressed market participants, herding behaviour among investors, and loss of liquidity that gives way to general flight to quality can all lead to heightened correlations between markets and, in extremely circumstances, set off a self-filling crisis on a regional/global scale. There have been clear signs over the past week that the distress in the Greek government bond market is increasingly being felt in other euro area countries such as Spain and Portugal. The most likely explanation of this development is the “demonstration effect” – the Greek crisis is likely to have caused investors to re-evaluate the fundamentals of these countries. Spain and Greece may not have strong financial or economic links, but their fundamentals have a lot in common.

The possibility of contagion of the Greek crisis may not end with Spain. There is a presumption among investors that in the worst case scenario (and we are not there yet) the EU will give Greece financial assistance. If this is an isolated event, the effect on the overall public finances of the EU is unlikely to be substantial. However, a bailout of Greece may make aid to other countries in similar situations more likely (moral hazard). A series of open-ended bailouts would not only undermine the fiscal positions of core euro area countries such as Germany and France but, more dangerously, would weaken their political commitment to the continuation of the euro area project.

This is probably why Greece is exerting what may seem to be a disproportionate influence on the markets of other euro area countries...

If it was a mistake three months ago to view the Greek crisis as a localized event, it would be a mistake now to see it as a euro-area-specific event. Indeed, global sovereign risk premia, which declined steadily in the first half of 2009, have been all moving higher at varying speeds since last September..."