Containing Contagion: A New Book by MIT Sloan Professor Brenda González-Hermosillo Measures How Financial Crises Spread Across Markets Around the World

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Findings have implications for policy that could mitigate the effects of future meltdowns

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As markets have become more globalized and interconnected, the potential for contagion to destabilize the world economic system has greatly increased

In recent years, investors have learned about financial contagion—the phenomenon where one country’s economy is jolted because of changes in the asset prices of another country's financial market—the hard way. In the summer of 1997, the Thai government was forced to float its currency, the bhat – a move that sparked the Asian financial crisis. In the fall of 1998, the Russian debt default and the near-collapse of the largest hedge fund in the US at that time, Long-Term Capital Management (LTCM), led to an acute shake-up in global markets. The financial crisis that began in mid-2007, resulting from the collapse of the subprime mortgage market in the US, led the world's economic system to seize up. And the recent bailout of Greece to prevent the country from defaulting on its debt is still reverberating across Europe as other countries, such as Ireland, are facing severe difficulties.

Just how and why crises spread from country to country, or asset class to asset class, is the subject of a new book by Brenda González-Hermosillo, visiting professor at MIT Sloan School of Management. The book, Transmission of Financial Crises and Contagion,* examines several episodes of contagion during the past decade, including the financial crisis in Brazil in 1999, the dot-com bust in 2000, and the recent global financial meltdown. The book also provides a general empirical framework, which can be used to model and measure the effects of contagion on markets around the world.

“As markets have become more globalized and interconnected, the potential for contagion to destabilize the world economic system has greatly increased,” she says. “That’s why it’s critical for investors and policy-makers to understand the risks of contagion: when it’s happening, and when intervention might be necessary.”

González-Hermosillo, along with co-authors Mardi Dungey, a professor at the University of Tasmania and Cambridge University (CERF), Renée A. Fry, a fellow at Australian National University, and Vance L. Martin, a professor at the University of Melbourne, examined 10 year’s worth of daily financial data for equity and bond markets from more than seven advanced and emerging market economies.

“There are many instances where one country’s financial woes impact another country, but oftentimes that is a natural market movement—a logical way for markets to find equilibrium prices,” she says. “Our book uses empirical research to differentiate between natural market movements—what are known as spillovers—and the additional movements that indicate the destructive forces of contagion.”

González-Hermosillo, who is on sabbatical from her position as deputy division chief of global financial stability in the Monetary and Capital Markets Department at the International Monetary Fund, says that the biggest difference between the two is that contagion is typically prompted by extreme uncertainty. “Contagion can create a self-fulfilling destabilizing effect,” she says. “Take, for example, the run on banks during the Great Depression. Not all banks were in dire straits, but customers saw long lines of depositors taking money out of certain banks and proceeded to withdraw money from their own bank because they did not know if all or only some banks were insolvent. The phenomenon generated its own momentum: as more people withdrew their deposits, the likelihood of default increased, which encouraged further withdrawals. More recent episodes of contagion also share similar characteristics, except that they have occurred in much more complex settings as financial markets have become more sophisticated and interconnected across national boundaries.”

Her book has important policy implications to reduce the risk of financial contagion. “Regulators, investors, and policymakers must work together to develop globally coordinated policies that mitigate contagion and the spread of crises,” says González-Hermosillo.

She notes that organized exchanges have rules stipulating that trade be temporarily suspended when, for instance, there is a lot of uncertainty and assets are at risk of becoming illiquid. This happened after the terrorist attacks of 9/11.

“These types of rules appear to lessen the effects of contagion,” she says. “There are examples in different fields where policies are introduced to contain contagion. During health crises like the Asian flu or the H1-N1 pandemic, schools closed while airports screened for people with related symptoms, and governments introduced coordinated communication plans. It’s a similar situation with financial markets. The goal is to find a coordinated policy response that reduces uncertainty and contains the risk of financial contagion before there is a meltdown. You want to limit panic.”

*Transmission of Financial Crises and Contagion: A Latent Factor Approach by Mardi Dungey, Renée A. Fry, Brenda González-Hermosillo, and Vance L. Martin; Oxford University Press, to be published in 2011

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