Stocks, bonds and currencies around the world were gyrating early in 2015 as investors worried about the potential repercussions of various scary scenarios, such as a Greek exit from the euro area, a deflationary spiral in Europe or a debt-fueled disaster in China. Experience offers good reason to prepare for the worst. Financial crises in Asia and Russia in the late 1990s led to a global selloff and the demise of Long-Term Capital Management, then one of the largest U.S. hedge funds. In the late 2000s, the subprime mortgage crisis tore through the global financial system, setting off a worldwide recession. Regulators lack a financial early-warning system to reliably tell them who stands to suffer the biggest losses when a country or company runs into distress. Such uncertainty alone can trigger contagion as nervous investors react to rumors and dump assets that they think might be affected. Even unfounded fears can become self-fulfilling when market routs trigger financial failures and panicked lenders starve companies of credit.
Economists have identified various conditions that make contagion more likely to occur. When, for example, a country spends beyond its means and depends heavily on short-term foreign borrowing, it’s more likely to get punished at times when investors grow uneasy. Also, the financial system becomes vulnerable when banks and other institutions make investments using a lot of borrowed money. That’s because losses can quickly render such leveraged investors insolvent or trigger added collateral demands from creditors, forcing them to raise cash by selling assets in other countries or markets. What’s harder to grasp is why investors sometimes react suddenly to problems they could have seen earlier — such as the extreme level of U.S. house prices in the mid-2000s. Part of the answer is herding behavior: When investors are piling in and pushing up prices, even bad investments can offer good returns. Money managers may have no choice but to join in, lest their performance fall behind their competitors’. It often takes shocking news, such as the freezing of three mortgage investment funds at the French bank BNP Paribas in 2007, to shift the dominant emotion from greed to fear.
How best to battle contagion remains a much-debated question. The International Monetary Fund has suggested that there may be cases where it makes sense to erect barriers limiting investors’ ability to shift their money in or out of countries. Others say such measures can inhibit desirable investment and do little to protect a country’s financial markets. Ultimately, the most reliable antidote is sound long-term economic and financial policy, according to Kristin Forbes, an authority on contagion at the Massachusetts Institute of Technology. This means policy makers should try to make sure that their countries don’t binge on borrowed money, and that their financial institutions have ample capital to absorb losses.
The Reference Shelf
- MIT professor Kristin Forbes argues that good economic policy can reduce the risk of contagion much as lifestyle changes can reduce the risk of disease.
- A classic 2000 article in the World Bank Research Observer explores irrational impulses that sometimes cause investors to flee markets.
- World Bank economists wrote in 2009 about isolating the role of uncertainty in contagion.
- Three economists boil down the prerequisites of contagion to three: surging capital flows, leveraged investors and surprise.
- The International Monetary Fund suggests that capital controls might be useful as an antidote to contagion.