Overview: Contagion in Finance
Contagion refers to the spread of financial or economic issues from one sector or market to another. It initially occurs domestically, but given the interconnected global economy, it generally spreads internationally. Financial contagion may be compared to a virus, as both share similar characteristics.
Since global economies integrate their domestic financial system with the international one, they accept contagion risk. The cross-border flow of capital, goods, services, and labor creates an interconnected global economy. Changes to supply and demand in one sector, region, or economy can spread, usually throughout the financial system, resulting from excessive debt and accompanying bubbles.
What is Contagion in Finance?
One straightforward example is when a crash in one market, like housing in the US, ripples through to another market, such as the US stock market, and then spreads internationally, as was the case during the 2008 global financial crisis, from which the global economy struggled to recover. Central banks flooded the financial system with capital and long-term counterproductive monetary policy until 2021, which fueled numerous bubbles, expanded debt, and caused inflation to become deeply embedded into the global financial system. It created a massive contagion risk, especially if stagflation, high inflation, and sub-par economic performance follow a recession.
Characteristics of Contagion in Finance
Contagion begins as a concentrated development in one sector. It starts slowly, setting deep roots while markets expand on the surface, creating an illusion of strength. It can take several months or years for a contagion crisis to develop, fueled by reckless monetary policy and market behavior. The 2007 US subprime mortgage crisis leading to the 2008 global financial crisis reflects how the contagion process can develop.
Excessive debt and a financial crisis spark contagion, which then spreads, initiating a downward spiral. Central bank and policy errors to address short-term problems follow, ignoring the long-term impact, and ensuring the next crisis, often a decade later. Studies have revealed that since the first identified contagion in 1825, every decade since featured a financial contagion event.
Dynamic, well-diversified markets can buffer contagion effects, while fragile, concentrated markets may face collapse. For example, the 1997 Asian Financial Crisis, when the term contagion emerged, spread across emerging markets across the region before reaching Russia, Eastern Europe, and Latin America, but China withstood it.
The Impact of Contagion in Finance
While contagion primarily occurs due to excessive debt leading to a financial crisis, its consequences depend on the state of the economy. A flexible, diversified economy can withstand contagion effects. Fragile economies might collapse, requiring an international bailout, often funded by more debt, setting the stage for another contagion event.
Since contagion originates from a debt problem, more debt-funded short-term solutions cannot fix structural issues. It explains why the global financial system witnessed one contagion event roughly every decade since 1825, when the first contagion, sparked by the Bank of England, rippled through the economy.
Short-term fixes lead to more long-term problems. For example, following the 2002 Dot Com Crash, the 2007 subprime mortgage crisis in the US lead to the 2008 global financial crisis. Central bank monetary policy and government actions laid the foundation for the current inflation problems, which could result in a prolonged period of stagflation.
Central banks fueled inflation for almost thirteen years, maintaining a zero-rate interest rate policy, and flushed the struggling economy with liquidity. Governments magnified the problems with debt-funded relief programs and blamed the crisis on external factors. Central banks failed to recognize their errors and raced to hike interest rates while economies slowed, and global debt surged past $300 trillion.
The Causes and Consequences of Contagion
Market participants must understand the causes and consequences of contagion, as it can help identify contagion stock market developments, where most feel direct exposure.
The causes of contagion
- Excessive debt leading to a financial crisis
- Central bank monetary policy errors accumulating for years
- Government policy missteps and debt-funded programs
- Fragile economies with concentrated needs
- Lack of market flexibility
- Hurdles to business entries and exits and difficulties in adjusting business models
The consequences of contagion
- Financial volatility and extreme losses, often the most notable asset destruction per decade
- Macroeconomic shocks
- Supply chain and trade disruptions
- Rising borrowing costs
- Counterproductive long-term policy changes
- Behavioral changes by market participants resulting in bear markets
- Competitive devaluations
- Capital flow changes and reduction in foreign direct investment
- Prolonged depressed economic activity
- Stagflationary risks if inflation anchored itself into the structural economic framework before the contagion
The Importance of Contagion Crisis Management
The “what is contagion in finance” debate is ongoing, but experts must recognize contagion risks in their initial phase to mitigate their fallout. History confirms that this has never occurred, allowing contagion to impact the global financial system approximately once per decade since 1825.
Asymmetric information flow resulting in unsustainable investments and reactionary market downturns magnify contagion effects, weakening markets as contagion spreads throughout the financial system.
Debt remains the primary culprit, and with global debt levels exceeding $300 trillion in 2021, the next contagion event is not a question of if but when and where.
Historical Examples of Contagion
Several notable contagion events materialized since 1825. While a crisis occurred every decade since then, not all had massive contagion effects.
Here are some historical contagion examples:
- 1825 - Bank of England induced stock market crash
- 1847 - End of railway industry boom
- 1866 - International financial downturn
- 1873 - The Long Depression (lasting until 1896)
- 1929 - The Great Depression
- 1979 - Energy crisis
- 1980 - Latin American Debt Crisis and global recession
- 1986 - Japanese Asset Bubble and US savings and loans crisis
- 1990 - Global recession
- 1997 - Asian Financial Crisis
- 2007 - Global Financial Crisis
- 2009 - EU Sovereign Debt Crisis (lasting until 2019)
- 2020 - Stock market crash
Conclusion
Contagion usually starts with excessive debt and a financial crisis in one sector, and the ripples through the system due to the interconnectivity of the global financial system. Besides the interdependence of markets, consumers and businesses can substitute identical resources, goods, and services. Therefore, disruptions to supply and demand spread throughout the chain quickly, followed by financial contagion, which occurs roughly every decade in one market, linked to central bank monetary and government policy mistakes, often resulting from the previous contagion event.
FAQs
How does contagion affect the financial system?
Contagion refers to the spillover effect from a crisis in one sector to another. Therefore, it weakens the financial system, causing massive losses and inviting monetary and policy errors with long-term negative effects that can magnify the next crisis roughly a decade later.
What does contagion mean in real estate?
The real estate market is highly fragmented, with local supply and demand creating notable differences, despite identical core costs. Real estate contagion begins in one localized market and spreads across other markets, linked via the financial system. For example, the collapse of a national mortgage lender will impact the entire real estate market it serves.
What is contagion risk in banking?
The contagion risk in banking, linked via counterparty risks, usually begins with one well-integrated bank facing losses, addressed through a fire sale of assets. It impacts its counterparties and decreases the overall confidence in the banking system, causing contagion to spread through the global financial system.
Does contagion take effect immediately?
Contagion can take months or years to build, and it takes several months to filter through the global financial system, despite the ultra-fast technological links. Each affected party attempts to resolve the issues, which requires time and prevents a faster contagion spread. From the beginning to the end, contagion can take years to complete, while its impacts last longer, usually until the next contagion event.