What began as a singular sovereign debt problem in Greece in 2009 quickly spread to the rest of Europe. First Ireland; then Portugal and Spain and Italy. Today—only three years after the first signs of trouble—virtually all Europeans have felt the destructive effects of the euro zone turmoil, and its impact is being felt around the world.
Contagion, a phenomenon where financial tumult in one country or region spreads to another country, is now a fact of life. The globalization of finance has, in many ways, made contagion inevitable. The world has become much more integrated through trade, investors, and banks, and these ties have caused countries’ financial markets to move together more closely during good times and bad.
Increased interdependence causes extreme negative events in one country to quickly affect others—a fact that much of the global business community appreciates. Right now, for instance, American business leaders are holding back on investment and hiring, which is a huge drag on growth. Why? Because they have three big question marks hanging over their heads: Will there be any resolution to the financial crisis in Europe? Is the slowdown in China a short-term blip or the start of a longer slump? And what is the future of US fiscal policy? What’s noteworthy is that two of these questions are international. That is a big change from even 10 years ago, where a factory owner in, say, a small town in Ohio wouldn’t necessarily have been worried about whether or not the European Commission is going to create a sweeping new central banking system. The point is: our corporations are holding back on investing and bringing on new employees because they are aware that the U.S. is exposed to other countries’ current and potential economic woes.
While exposure to the international economy is hard to completely avoid, some types of contagion are temporary and even avoidable. According to my recent research*, one lesson from Europe’s financial crisis is that an over-leveraged banking system increases vulnerability to contagion. In fact, leverage appears to be a more significant determinant of country vulnerability than the total international exposure of a country’s banking system. This suggests that limiting leverage and implementing strict capital requirements should be considered as a policy to decrease the risk of contagion in the future.
Another key lesson is that there is no replacement for good macro-fundamentals. Excessively-leveraged countries are much more susceptible to shocks (note Italy); countries that have better control of their debt levels and a handle on their budget deficits (note Germany) tend to be more resilient. Countries are also less vulnerable to contagion if they do not bias investments away from equities towards debt, and if they have larger international investments abroad (which can provide a buffer against shocks).
There is a lesson here for foresighted U.S. policymakers. The best approach to minimizing the threat of contagion is through fundamental structural reforms before a negative shock occurs and financial infection from a troubled foreign economy is imminent. A top priority for Washington lawmakers should be to reduce leverage in the banking system and reduce overall government debt levels. Policymakers should also avoid policies that give preferential treatment to debt over equity, as well as support portfolio investors’ efforts to diversify and invest abroad.
Adopting policies that strengthen our economic fundamentals is, of course, just good common sense. The risk of contagion merely provides an extra incentive to embrace such reforms sooner rather than later. Because once problems emerge somewhere else in the world, contagion can occur so quickly that there may no longer be enough time for the medicine to work.
* The “Big C”: Identifying and Mitigating Contagion* By Kristin J. Forbes; MIT-Sloan School of Management; 2012
Kristin Forbes is the Jerome and Dorothy Lemelson Professor of Management and Global Economics at MIT’s Sloan School of Management. She served as a Member of the White House’s Council of Economic Advisers from 2003 to 2005, where she was the youngest person to ever hold this position, and currently serves as a member of the Governor’s Council of Economic Advisers for the state of Massachusetts.