“Contagion” is one of the most carelessly employed words in this era of financial turmoil. It is a medical metaphor, applied to economics. It invokes a situation in which an unhealthy individual infects other, otherwise healthy individuals. In an economic/financial context, the insolvency of one institution (a country, a firm, a bank) causes the insolvency of another, or others.
This can occur, of course. The failure of a financial institution imposes losses on its counterparties, and these losses may jeopardize their solvency. But the term is often used to describe any situation in which multiple institutions get into trouble simultaneously even though this can occur without contagion proper. Many institutions can be subjected to a common shock that causes several of them to become insolvent, or teeter on insolvency. That’s not really contagion.
For instance, during the Great Depression, many banks failed even though most of these banks did not have any transactions with one another; they failed because of a common macro shock that hit the entire banking sector, and the entire economy for that matter. Similarly, during the S&L crisis many thrifts who basically dealt only with their borrowers failed simultaneously because they engaged in similar activities and were hit by a common shock (primarily, they lent long term at fixed rates, borrowed short term at floating rates, and got hammered by inflation and rising interest rates).
Right now the c-word is being used repeatedly in conjunction with the European financial crisis. Yes, there are some interconnections that are exacerbating the crisis, but this isn’t really a contagion, properly understood.
Greece and Ireland and Portugal and Spain and perhaps soon Italy and Belgium are facing catastrophic financial and fiscal situations. That’s because they all made the same mistakes and are suffering from the same economic problems. All borrowed profligately. Ireland and Spain in particular had housing booms that went bust. All (with the exception perhaps of the Irish) have uncompetitive economies. So they are all suffering financial crises together. But in the first instance, the crisis of one is not causing the crisis of the others. The fact that somebody in Las Vegas borrowed a huge amount to buy a house that has plummeted in value is not the cause of the financial distress of another somebody in Florida how borrowed a huge amount to buy a house that plummeted in value: they just made the same borrowing decisions, were hit by the same economic shock, and hence are in the soup at the same time. Nor is, for the most part, the fact that Greeks borrowed in excess the cause of Irish financial woes: those woes are due to the fact that the Irish borrowed too much too.
If tomorrow the Irish discovered all of the leprechaun gold, would that help the Greeks or the Portuguese? Some, but not much. Yes, the Irish could pay off their loans and they would be free of their financial crisis. But the Portuguese and Greeks and Spaniards and Italians would still be groaning under the weight of their past borrowing excesses. If the problem were contagion, properly understood, the leprechaun gold would benefit the Greeks, et al, not just the Irish.
There are interconnections, to be sure. Spanish banks have bought Portuguese government bonds, for instance, and Portuguese banks have bought Greek bonds. So a Portuguese default would hurt Spain, and a Greek default would hurt Portugal. But the fact remains that if the Greek banks had only bought Greek bonds and the Spanish banks had only bought Spanish bonds and the Portuguese banks had only bought Portuguese bonds they would all still be feeling the big hurt. Regardless of whether they bought each others’ crap, or just their own, they would all be in crisis due to the fact that all of these economies are overleveraged and have poor growth prospects.
Perhaps the more interesting case is that the French and the British and the Germans are net buyers of PIIGS debt. This means that the travails of the Irish, et al, hurt the banks and other investors in the more financially sound countries. Indeed, these losses may be big enough to put some major German or French or British banks at risk of failure. That would be more like contagion, but that’s not usually the way the word is used in stories about the situation: it’s more often said that the Irish crisis is putting Portugal or Spain or Italy under stress.
The problem with bad metaphors (mental models/framing) is that it can lead to incorrect diagnoses, and incorrect policies in response to the problems. As I wrote back in March, during the previous spasm of the crisis (its Greek phase), if the real contagion problem is German or French banks, its better to deal with those problems directly rather than via elaborate money laundering schemes. That’s especially true since these schemes risk perpetuating the moral hazards that were the primary source of the problem in the first place: it is rather amazing to see the Germans and Merkel get blasted for suggesting that bondholders must take haircuts as part of any relief plan. If going forward bondholders figure they can offload their problems to taxpayers when things go bad, the overleveraging will never end.
The brute fact is that the amount that the PIIGS (and probably Belgium too) have borrowed far more than they can afford to pay. Somebody has to eat the loss. Deciding who will be an ugly, ugly process. But the ugliness will recur unless the borrowers and the lenders bear the brunt.
So a word to the wise. Be on alert when you hear the word contagion used. More often than not it is used sloppily; encourages sloppy thinking; and leads to sloppy actions.