Small Economies, Big Problems, and Global Interdependence

Greece’s GDP, at about $300 billion, represents approximately 0.5% of world output. Its $470 billion public debt is very large relative to the Greek economy’s size, but less than 1% of global debt – and less than half is held by private banks (mainly Greek). Barclays Capital estimates that only a few globally significant foreign banks hold close to 10% of their Tier 1 capital in Greek government bonds, with the majority holding much less.

So, at least on paper, Greece should not be a systemically important economy. Yet there are several reasons why the Greek crisis is having substantial spillover effects. Moreover, Greece is not alone in this respect.

First, in the Greek case, there is the fear of contagion to other distressed European economies, such as Portugal and Ireland, or even Spain and Italy. There are also substantial investments by American money-market funds in instruments issued by some of the exposed banks.

Then there are various derivatives, such as credit-default swaps, through which banks holding Greek debt have insured themselves against non-payment. If CDSs are concentrated in particular financial institutions, these institutions could be at risk – more so than the primary purchasers of Greek debt themselves. But no one knows who is holding how much of these derivatives, or whether they reduce or magnify the risk, because CDSs are not transparently traded on open exchanges.

Finally, Greece’s difficulties imply problems for managing the euro, as well as possible disorderly behavior in foreign-exchange markets, which threaten to augment uncertainty and negatively influence the already-weakening global recovery. Clearly, the world economy has a large stake in Greece’s recovery.

In the same vein, consider a completely different case, that of Yemen. Greece and Yemen have no relevant similarities, except the contrast between their size and possible spillover effects. Yemen’s GDP is only 10% the size of Greece’s, representing 0.05% of global output, and its economy is not significantly linked to the international financial system.

But Yemen’s population is close to that of Saudi Arabia, and its border is very hard to control. Chaos in Yemen, coupled with the growing strength of extremists, could seriously destabilize Saudi Arabia and threaten oil production. In that case, the price of oil could shoot up to $150 a barrel or more, dealing a heavy blow to the global economy.

One can find other examples of this kind. Recall that the 1997 Asian crisis started in Thailand – again, not a large economy. The strong trade, financial, and natural-resource-related interconnections that have developed in the world economy turn many otherwise small countries, or problems, into global systemic risks.

The implications for global economic governance need to be understood and addressed. At the Seoul G-20 summit in November 2010, the assembled leaders encouraged the International Monetary Fund to work with the Financial Stability Forum to develop an early-warning system for global financial risks, and to analyze spillover effects on “large economies” (China, the United States, the United Kingdom, Japan, and the eurozone).

The spillover reports are currently being discussed by the IMF’s board. A synthetic report by the Fund’s Managing Director is to be presented to the International Monetary and Financial Committee when officials from the IMF’s member states meet in September.

This step, if pursued seriously, would enable a deeper analysis of interdependence in the world economy. It could also increase the IMF’s legitimacy as an institution that is global not only in its membership, but also in its treatment of different types of members. So long as the IMF’s macroeconomic surveillance was in fact applied only to developing countries, with the G-7 and other rich countries evading a serious monitoring process, the Fund could not be perceived as fair and impartial.

As these examples indicate, however, systemic importance is not just a question of size. What matters is the interconnections that link a particular country, institution, or group of institutions (for example, Lehman Brothers and AIG) to the wider world economy.

Surveillance of systemic risk must proactively test and analyze these interconnections, and try to imagine the “hard to imagine.” After all, as we now know only too well, systemic risk can emerge in unexpected places.

Interdependence has become much more complex than it was even a decade ago. The IMF needs to be empowered to analyze the macroeconomic and macro-financial risks that have emerged, establish an early-warning system, and propose possible preemptive policy measures. The Fund’s almost universal membership and its staff’s technical expertise should enable it to carry out effective multilateral surveillance, provided that it accelerates its own governance reforms, so that surveillance is perceived as being in everyone’s interest.