Contagion effect: How financial crises spread across borders

Debt levels and fiscal characteristics can signal that a country may succumb

In December 2008, as the havoc of the global financial crisis (GFC) was in full swing, Britain's Queen Elizabeth was visiting the London School of Economics and took the opportunity to ask her hosts: "Why did no one see it coming?"

Even the International Monetary Fund had misread the signs. In April 2007, its World Economic Outlook concluded that the economic slowdown in the US was unlikely to spill over into the rest of the world as long as America's problems remained confined to its troubled housing market.

Of course, by the end of 2007, wild lending in the US housing market had spawned a subprime mortgage crisis that did cross borders, triggering the GFC (known in the US as the Great Recession). The repercussions are still rippling through Europe where the search for solutions remains arduous.

"There's never a silver bullet explanation for all crises," says James Morley, a professor of economics and an associate dean at UNSW Business School.

"Every crisis is different in its sources, which makes it very hard to predict what the source of the next crisis will be. We're always fighting the last war, as such."

Morley has been studying financial crises for more than a decade. In his latest paper, Debt and Financial Market Contagion, Morley and co-author Cody Yu-Ling Hsiao examine the period of 2007-2013 and investigate how crises in equity markets spread across countries during the three episodes of the US subprime mortgage crisis, the GFC, and the ongoing European sovereign debt crisis.

'Some people refer to the bond market vigilantes, but it's actually not just bond markets, it's equity markets as well as currency markets'


Financial linkages

"There were a lot of financial market connections to the US housing market that weren't really well understood by policy-makers, or even the financial industry, at the time," Morley says.

"In particular, European banks had invested a lot, indirectly, in sub-prime mortgages and when the crisis hit they discovered their balance sheets were in much worse shape than they previously thought.

"So the crisis spread not necessarily because of the old saying – when America sneezes the rest of the world catches a cold – a quip that captures the idea of a crisis spreading through traditional economic linkages such as international trade flows, but instead it spread through financial linkages."

And not just direct financial linkages. The authors find that during crises, financial markets identify other countries that have similar troubling characteristics and can exacerbate those problems by taking their business elsewhere.

"You find financial markets looking around and saying, 'If this happened to the US, what other housing markets are at risk of some sort of collapse?' And economies such as Spain and Ireland with inflated housing markets, even with small direct trade links to the US, came under the financial market scrutiny," Morley says.

"Some people refer to the bond market vigilantes, but it's actually not just bond markets, it's equity markets as well as currency markets." 

Europe's constant crisis

The European sovereign debt crisis is something new. Examining the way it morphed from the GFC leads back to the structure of the European banking system.

"The whole development of the EU led to local or national banks being able to lend money outside of their own countries, with Iceland being the most extreme example. Iceland, a country of some 300,000 people, had a significant banking system where a lot of loans were being lent throughout Europe and ultimately tied back to US mortgages as some of the underlying assets," Morley explains.

"So the European crisis comes out of that evolution of financial markets to allow for cross-border lending on a massive scale. But when there's a crisis, at some point if it's extreme enough, then the banks are not well enough capitalised. You can have a bank run – such as with Britain's Northern Rock – and you end up with banks having to be bailed out by a government and the government has to issue debt to fund that."

Morley describes the EU as a "grand experiment" – a common currency across many different countries, supposedly on equal footing. But this new institutional structure for an economy lacks a common political entity, which makes governance uncertain in times of crisis, and provides no effective mechanism for a co-ordinated response.

"The European problem is: who's responsible? There are national governments in countries that are quite small compared with their banking system and so it's very costly for them to issue enough sovereign debt to address the crisis," Morley says.

"So that's why it's ongoing. There are negotiations over the level at which the bailout would happen. Does it happen at a national level, or does it happen at a European-wide level given that the lending had gone on at a European-wide level?

"The scale of debt is too large to allow for a bailout at a national level."

'The one thing I can say with near certainty is that 50 years from now we will still be talking about a recent financial crisis'


Warning signs

If upcoming crises are too difficult to spot, are there at least factors that signal when economies may be at risk?

"Fiscal characteristics like debt levels and deficit levels are quite important," Morley says.

"In one sense you might say that sounds obvious – countries that have a lot of public debt, or where public debt is growing a lot, are at risk. But why it's not obvious is that you can immediately come up with counter examples, such as Japan – it always comes out in the top of the league tables in terms of debt to GDP ratios, but the financial crisis didn't really transmit to Japan in a big way."

Morley reiterates that there's no silver bullet explanation for the spread of crises, but says his research suggests a combination of factors.

"It's when you've got a mix of where a country is located, trade flows to a much lesser extent, and debt conditions – not just public debt, but high personal debt levels and high external debt levels. These factors combined definitely put countries at greater risk than otherwise. But it's not entirely deterministic, and the good news about that suggests that policy can respond to try to mitigate the potential for a crisis," Morley says.

"When there is a crisis elsewhere, policy-makers need to think beyond what the direct trade linkages are, but consider the potential for a financial market spillover. They may need to take out insurance, as such, against the spread of a crisis by adjusting interest rates, not just based on what they think will happen to foreign demand conditions, but also financial markets as well."

In fact, policy-makers have learnt from research into previous crises – the US Federal Reserve's response to the GFC was successfully informed by the mistakes made in dealing with the Great Depression, and Australia, too, benefited from accumulated knowledge in charting its course during the GFC, which it weathered well enough that it was really more of a "North Atlantic Financial Crisis" than a GFC, according to Morley.

"It's probably too high a bar to say that we should be able to predict crises with great certainty, and definitely too high a bar to say we should be able to predict crises in such a way that we can construct policies that will eliminate all crises," Morley says.

"The one thing I can say with near certainty is that 50 years from now we will still be talking about a recent financial crisis."

James Morley's other research on financial market contagion includes an earlier article in the Journal of International Economics and a forthcoming article in the Journal of Economic Surveys.


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