Don't Fear the Grexit

Greece is not Lehman Brothers, and the global economy will be just fine if it drops out of the eurozone.

The news Wednesday that European Union finance ministers may be preparing contingency plans for a Greek exit from the eurozone sparked a fresh round of commentary about global financial turmoil in which financial writers interpreted perfectly ordinary market performance in the United States as a "selloff" triggered by the Greek crisis.

Renowned commentators are also ringing the alarm bells. New York Times columnist Paul Krugman recently predicted that "[t]hings could fall apart with stunning speed, in a matter of months, not years. And the costs -- both economic and, arguably even more important, political -- could be huge." The developments in Greece even have some commentators invoking the spectacular collapse of Lehman Brothers, which touched off the greatest global financial crisis and economic depression since the 1930s, and has called into question the resilience of global governance institutions. Over at the Financial Times, Martin Wolf argues that the "danger of contagion" from a Greek departure "is obvious," that "the risk that a bigger eurozone upheaval would cause a global crisis is real," and that the fallout "would be worse than [the aftermath of] Lehman Brothers' failure in 2008."

Can we all take a deep breath now?

Our research on global financial networks indicates that these concerns are overstated. Further economic and financial deterioration in Greece would certainly have negative impacts there and might adversely affect Greece's southern European neighbors, who are facing similar circumstances. But financial weakness in Greece is unlikely to spark a global crisis analogous to the one triggered by Lehman Brothers' collapse in September 2008 -- even if economic woes eventually force Greece to exit the monetary union. Instead, the global consequences of southern Europe's debt crisis are more likely to resemble the Latin American sovereign debt crises of the early 1980s, the East Asian crises of 1997-1998, and Argentina's crisis at the turn of the millennium. Each of these had significant local effects -- widespread bank failures, sharp increases in unemployment, large exchange-rate devaluations, deep recessions -- that were not transmitted globally. Indeed, in each of these cases the global economy continued to grow (see the graph below), major world equity markets held their value, and world trade expanded. None had the dramatic global consequences sparked by Lehman's collapse.

As the graph below demonstrates, the recent subprime mortgage crisis, which hit the center of the financial system, took a far greater toll on the global economy than the peripheral crises that struck East Asia and Argentina and primarily inflicted regional damage.

To understand why the global fallout from the Greek crisis is more likely to resemble Argentina than Lehman Brothers, let's remember what financial contagion is and how it spreads through the global financial system. Contagion occurs when an asset's value declines so much that banks and other financial institutions that own it are rendered insolvent. Insolvent banks cannot meet their obligations to their partners, which drives these "counterparties," as they're known in the finance world, toward insolvency as well. This is what happened with Lehman Brothers: Its mortgage-backed securities holdings lost so much value that the bank could not cover the debt it owed to the financial firms from whom they had borrowed. The resulting loss of capital in those firms weakened their balance sheets. This cascade of weakness through financial networks was aggravated by uncertainty about who owed what to whom and the consequent inability to evaluate the risk of transactions with any financial institution. As a result, interbank lending and short-term credit markets froze. This is how contagion spreads throughout the dense web of connections that make up global financial markets.

Because these global financial network connections have strengthened dramatically over the past several decades, there is now widespread concern that a crisis that hits anywhere can lead to instability everywhere. What's often overlooked is that how countries are connected -- not just where within the network a crisis originates -- has a dramatic impact on whether a local crisis sparks a global crisis. Lehman Brothers had a dramatic global impact because Lehman operated at the center of the U.S. financial system -- the world's most connected market. Moreover, Lehman Brothers' failure occurred as part of a broader systemic crisis: The five largest U.S. investment banks and hundreds of U.S. commercial banks were reorganized or disappeared and many non-bank institutions, such as mortgage lenders and hedge funds, collapsed. The systemic crisis in the United States spread globally because 80 percent of the countries in the world had placed assets in these institutions in an amount well in excess of their capital. Weakness in major American financial institutions translated directly into weakened balance sheets in financial institutions everywhere.

Greece, by contrast, is on the periphery of the global financial system. Few countries have a substantial share of their assets in Greek banks or Greek sovereign debt. U.S. banks, for example, had $5.8 billion in direct exposure to Greece at the end of 2011, roughly the same financial exposure that they had to Israel and a little more than half as much exposure as they had to Finland. In other words, the world hasn't placed enough assets in Greece for default by the Greek government or the collapse of the Greek banking system to have far-reaching global repercussions. Some smaller firms that are less connected to the global financial system may suffer greatly from a Greek default. But these entities pose little threat to systemic stability, as we saw last year when the brokerage fund MF Global failed due to its exposure to European debt without triggering a broader crisis. For larger, more connected firms, exposure to Greece is such a small percentage of their overall asset portfolios that a Greek default is unlikely to cause insolvency. After all, JPMorganChase lost more than $2 billion on a side bet last week, but there was no threat of contagion. What's more, major firms and their regulators have had years to prepare for the possibility of a Greek default, and Greece's creditors have already discounted the value of the Greek debt they hold well below its face value (as much as 90 percent in some cases). There is not much left to lose.

What if a Greek default triggers defaults in Ireland, Portugal, and Spain? Here the situation would be more like the 1997 East Asian crisis, which had a significant impact on Indonesia, Malaysia, South Korea, and Thailand and a moderate impact on Hong Kong, Japan, Singapore, and the Philippines but was a temporary blip everywhere else. Since the crisis struck Asian countries on the periphery of the global economic and financial system, it mostly stayed in the periphery rather than infecting the rest of the world. Similarly, a crisis in Europe's south will be felt most in Europe's south, less intensely in Europe's north, and very little in the rest of the world.

In short, Greece is not Lehman Brothers. Lehman's failure triggered a global crisis because Lehman was at the center of the global financial network. Greece, in contrast, is at the periphery of this network. Global crises don't start in the periphery. While a Greek collapse would certainly be devastating for Greece and some of its neighbors, the rest of the world is likely to escape with minor disruptions to their economies.

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Amateur Hour in Chicago

Obama knows that he can't succeed in Afghanistan without coming to terms with Pakistan. So why is his diplomacy so lousy?

As last weekend's NATO summit made clear, President Barack Obama's Hamlet-like indecisiveness on Pakistan plagues his administration's relationship with the country and its president, Asif Ali Zardari. Obama remains unable to effectively manage the need to both apologize to and reengage Pakistan, while at the same time moving the country away from supporting militant groups that destabilize it and the region.

Since November, the Obama team has agonized over whether it should apologize for the deadly U.S. air attack on a Pakistani Salala military base along the border with Afghanistan. Twenty-four Pakistani soldiers died as U.S. helicopters fired on the Salala base for two hours, including more than an hour after Pakistani liaisons pleaded for the attacks to stop. The Wall Street Journal reported this month that planned apologies to Pakistan were aborted numerous times -- including once after Qurans were found to be desecrated by U.S. soldiers in Afghanistan. Washington has expressed "regret" and offered its condolences for the incident.

For all the importance Obama claims to place on Pakistan, he has taken a back seat in directing the sinking partnership with Islamabad. In the extensively sourced Wall Street Journal report, the president is missing from the narrative. The internal administration debate on whether to apologize to Pakistan seems to be one among principals, deputies, and senior aides. But the U.S.-Pakistan relationship is too important for Obama to delegate.

As a candidate, Obama argued not only that the war in Afghanistan, not Iraq, was the real post-9/11 war, but also that Pakistan holds more strategic importance for the United States than Afghanistan. In a June 2008 address, Obama said, "as president, I will make the fight against al Qaeda and the Taliban [in Afghanistan and Pakistan] the top priority that it should be." He added, "The greatest threat to that security [in Afghanistan and the United States] lies in the tribal regions of Pakistan." In Obama's first two years as president, his administration reviewed America's AfPak strategy not once, but three times, with numerous course corrections along the way. Numerous press accounts portray the president as deeply and very personally involved at key points in the decision-making process.

Contrast that with his behavior at the NATO summit: Initially, the White House told reporters the president would not meet with Zardari, a clear snub. But this clashed with the administration's strategy of enhancing and maintaining support with Pakistan's civilian democrats while taking the military to task. By summit's end, the administration backtracked -- realizing that a complete snub of Zardari could hurt Pakistan's fragile democratic transition -- and Obama held two "brief" meetings with the Pakistani president. The White House highlighted these interactions, yet emphasized that they were not especially substantive. Obama then awkwardly avoided mentioning Pakistan in his press conference at the summit's close. (He referred to NATO's commitment to bringing "peace and stability to South Asia, including Afghanistan's neighbors," but Pakistan is the only South Asian state that borders Afghanistan.) Finally, Obama gave an extensive response to the first question from the media, which was on Pakistan, giving the impression that his discussions with Zardari were wide in scope. The Obama administration's behavior was not carefully calibrated diplomatic messaging, but tactical maneuvering that was imprecise, difficult to decipher, and verging on passive aggression. It was amateur hour.

The president's refusal to apologize has kept U.S.-Pakistan relations frozen at last winter's nadir, and the spring has seen no thaw. Relations could have been back on track had the president swallowed his pride and allowed his diplomatic team to bring Pakistan on board to secure a lasting peace in Afghanistan.

Yes, the White House fears the Romney campaign could cast too many concurrent apologies as weakness. But economic and domestic, not global, leadership, will decide who wins in 2012. And the Obama campaign can refute claims of weakness on Pakistan by reminding voters that Obama not only unilaterally sent Special Forces into the heart of the Pakistan to kill Osama bin Laden but also vastly expanded the drone bombing campaign on Pakistani soil, over the vocal opposition of the Pakistani government and public.

A strategic convergence between the United States and Pakistan is possible. Neither wants civil war in Afghanistan. Both have leverage over different sets of belligerents in Afghanistan's intensifying internal feud. (Pakistan has the most clout with the Taliban and its Afghan allies, while the United States has working, albeit increasingly troubled, ties with a broad segment of mainstream Afghan factions.) But both lack a coherent, viable Afghanistan strategy. Washington hopes to hand over security control to Afghan forces its own troops believe are compromised by drug-abuse and thievery. Meanwhile, Islamabad has succeeded only in antagonizing most of Afghanistan's power brokers; its partners, the Taliban and associated militant groups, are incapable of taking over the country. Pakistan is the most disliked country in Afghanistan. And the longer instability prevails in Afghanistan, the bigger the strain on Pakistan's economy and security. A stable Afghanistan in which all major power brokers, including the Taliban, are brought into a legitimate and reasonably effective political process is in the interest of both Washington and Islamabad.

Though Pakistan is in a period of political transition -- new elections could take place as early as October -- Obama should engage Pakistani civilian leaders on how to best aid Afghans in resolving their civil war. Washington can help Islamabad in its outreach to non-Pashtun power brokers, such as members of the anti-Karzai and anti-Taliban National Front. Islamabad can in turn coax the Taliban and Haqqani network to join a sustained peace process. Only by working together can the United States and Pakistan serve as guarantors of a lasting, Afghan-owned political settlement.

Some might dismiss the idea of engaging Pakistan's civilians on security issues. After all, isn't the military in charge? But in the past year, Pakistan's federal cabinet and parliament have played a much more active role in forming the country's national security policy. Civilian oversight bodies, such as the prime minister-led Defense Cabinet Committee, have been remarkably more proactive since the bin Laden raid. The Parliamentary Committee on National Security, led by Senator Raza Rabbani, has created a landmark set of recommendations on how to reshape ties with the United States. It's the product of consensus between secular ethnic nationalists, Islamists, and centrist parties. And last year, a conference consisting of all of Pakistan's major political parties resolved to "give peace a chance" and back out of the war on terror.

Americans are tired of war. So are Pakistanis and Afghans. There is a collective realization that war is not the solution, but the road map for peace has yet to be charted.

President Obama has a diminishing but real opportunity to not simply exit from Afghanistan, but exit in a way that vastly reduces the prospects of renewed civil war. To start, he must break the impasse with Pakistan and engage its civilian leadership. But this time, the conversation can't be brief.

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