Contagion

What Is Contagion?

A contagion is the spread of an economic crisis from one market or region to another and can occur at both a domestic or international level. Contagion can occur because many of the same goods and services, especially labor and capital goods, can be used across many different markets and because virtually all markets are connected through monetary and financial systems.

The real and nominal interconnections of markets can act as a buffer for the economy against economic shocks, or as a mechanism to propagate and even magnify shocks. The latter case is typically what economists and other commentators refer to as contagion, with a negative connotation likening the effect to the spread of a disease.

Understanding Contagion

Contagions are typically associated with the diffusion of economic crises throughout a market, asset class, or geographic region; a similar effect can occur with the diffusion of economic booms. Contagions occur both globally and domestically, but they have become more prominent phenomena as the global economy has grown, economies within certain geographic regions have become more connected to one another, and economies have become more financialized.

Many academics and analysts see contagions as being primarily symptomatic of global financial market interdependence.

Usually associated with financial crises, contagions can be manifested as negative externalities diffuse from one crashing market to another. In a domestic market, it can occur if one large bank sells most of its assets quickly and confidence in other large banks drops accordingly. In principle, the same process occurs when international markets crash, with cross-border investment and trade contributing to a domino effect of closely correlated regional currencies, as in the 1997 crisis when the Thai baht collapsed.

This watershed moment, the roots of which lay in gross excess of dollar-denominated debt in the region, quickly spread to nearby East Asian countries, resulting in widespread currency and market crises in the region. The fallout from the crisis also struck emerging markets in Latin America and Eastern Europe, which is indicative of the capacity of contagions to spread quickly beyond regional markets.

Why Does Contagion Happen?

All markets in an economy are interconnected in some way. From the consumer side, many consumer goods are substitutes or complements to one another. From the producer side, the inputs for any business can be substitutes and complements for one another, and the labor and capital that a business needs may more or less be useful in different types of industries and markets. In a financial sense, the various markets in an economy generally all use the same type of money and rely on mostly the same types of financial institutions to facilitate the flow of goods and services through the economy.

This means that any modern economy is a vast and complex web of interdependent relations between producers, consumers, and financiers across all markets. Changes to the underlying conditions that determine supply and demand in any one market will have effects that spill over into other related markets. Depending on the structure and conditions of the economy, this can either make it more or less resilient to economic shocks.

What Makes Economies More Susceptible to Contagion

When markets are robust and flexible, the effects of a negative economic shock to one market can be spread out across many related markets in a way that reduces the impact of participants in any one market. Imagine dropping a steel ball bearing onto a trampoline. The impact gets spread out by the interwoven threads of the trampoline and dampened by the springs to which it is attached, without causing damage to the material.

On the other hand, when markets are fragile or rigid, a strong enough negative shock in one market can not only cause that market to fail, but spread serious damage to other markets, and perhaps the entire economy. In this case, imagine dropping the same steel ball bearing onto a large pane of window glass. It can not only break the glass at the point of impact but spread cracks or even shatter the entire window. This is what happens in an economic contagion, where a large shock to one market spreads cracks or shatters an entire economy.

This means that the major factor driving economic contagion between markets is the robustness (or fragility) and flexibility of those markets. Markets that are heavily dependent on debt; where participants are dependent on some specific commodity or other input; or where conditions prevent the smooth adjustment of prices and quantities, entry and exit of participants, and adjustments to business models or operations will be more fragile and less flexible.

The more fragile and inflexible any given market is, the more it will suffer from a negative shock. Moreover, the more fragile and inflexible markets are in general, the more likely that a negative shock in one market will develop into a contagion between markets.

Beyond the robustness (or fragility) of the individual markets themselves, the scale and intensity of connections between different markets also matters. Markets that are not, or are only weakly, interconnected to one another will not transmit shocks among one another as effectively.

Using the analogy from above, imagine dropping a steel ball bearing onto a dozen eggs. It will completely shatter one or two eggs, but leave the rest completely unscathed. This is a double-edged sword, however; avoiding interconnection among markets also means reducing the size and scope of the division of labor across an economy and the resulting gains from trade.

A Brief History of Financial Contagion

The term was first coined during the 1997 Asian financial markets crisis, but the phenomenon had been functionally evident much earlier. The global Great Depression, triggered by the 1929 U.S. stock market crash, remains an especially striking example of the effects of contagion in a heavily indebted, economically integrated global economy.

After the Asian financial crisis, scholars started to investigate how previous financial crises spread across national borders, and they concluded that the "nineteenth-century had periodic international financial crises in virtually every decade since 1825." In that year, a banking crisis that originated in London spread to the rest of Europe and eventually Latin America. In a pattern that has been repeated ever since, the roots of the crisis were in the expansion of debt through the global financial system.

After much of Latin America had been liberated from Spain in the early part of the 19th century, speculators in Europe poured credit into the continent. Investment in Latin America became a speculative bubble and, in 1825, the Bank of England (BoE), fearing massive gold outflows, raised its discount rate, which in turn sparked a stock market crash. The ensuing panic spread to continental Europe.