Containing Contagion

It started with Greece and its $100-plus billion bailout package last May. Next came Ireland: in November, it accepted a similarly hefty financial rescue. And now the European debt crisis is at risk of spreading like a virus to countries perceived by the markets to have similar vulnerabilities. Other countries that appear at risk for financial problems include Portugal, Spain and Italy.

As I watch these events unfolding across the Atlantic, the economist in me is fascinated to see that financial crises continue to be part of our landscape. I’ve spent a large part of my professional life studying how financial crises spread from country to country and Europe’s sovereign debt predicament is a living and breathing example of my academic research. Theoretical and empirical models help us understand pieces of otherwise complex dynamics that have been, and continue to be, the fundamental drivers of financial crises.

My biggest worry is that contagion often creates a self-fulfilling destabilizing effect that can spread otherwise ‘isolated’ episodes of stress to other markets and countries. It has a momentum of its own. And as the world’s economies are trying hard to pull through from the credit crisis and the global downturn that started in mid-2007, I worry about the immediate and longer-term challenges facing Europe. It’s clear that Europe is struggling mightily to prevent the debt crisis from overwhelming more countries and support a fragile recovery, but containing contagion is not easy.

Much of what’s happening now in Europe has to do with confidence. When investors see one country run into financial problems, they often become skeptical of the health of other countries that share similar economic and political characteristics. Right now, investors are scrutinizing nearly every country with high debt. Markets have pushed up borrowing costs for other vulnerable nations which threatens their financial and fiscal stability, and growth.

More meaningful research is needed to understand how financial crises spread and produce systemic events, but contagion is clearly one of the most important topics of our time. We have lived through nearly three decades of financial crises in a number of developing nations, and in recent years similar forces led to the deepest financial crisis in advanced economies since the 1930s. What began as a U.S. driven crisis in the subprime housing market in 2007, soon became a global phenomenon. What began as a problem driven by illiquid, and often insolvent, financial institutions also morphed into a sovereign debt crisis in part due massive guarantees extended by governments and central banks. Now, there is a risk that the current stage of sovereign difficulties, particularly in some European countries, could spread to other countries.

The spreading of these pressures and the risk of contagion continue to be an area of key interest for academics and policy makers alike. Failing to understand how these links can occur represents a very high risk and therefore research in this area remains as relevant today as it was during the Latin American and Asian crises of the 1980s and 1990s. What happens next in indebted countries in Europe and in other regions may be conditioned by the lessons that we have learnt (or not) from history. I hope to shed light on the main drivers that have led to the contagion of financial crises in the past, and thus lead to a better understanding of how to prevent similar outcomes today and in the future.

For more information about Brenda Gonzalez-Hermosillo, visit the MIT Sloan website at: http://bgh.scripts.mit.edu/.