Contagion Definition. Contagion is a phenomenon in which an economic crisis spreads from one market to another in much the same way as a disease spreads without recognition of natural boundaries. The recent debt crisis in Europe is a case in point. As the debt and deficit problems in Greece became evident in the daily press, concerns were raised that similar problems might spread to other “PIIGS” in the Eurozone. “PIIGS” was a euphemism for Portugal, Ireland, Italy, Greece and Spain. Economies in these other member states had been similarly impacted by the global recession and were having difficulty maintaining a sustainable recovery. Headlines questioned whether the “Greek Contagion” would spread to these countries, but government officials were quick to assess that issues in each state were different and unrelated to Greek problems.
Usually associated with financial crises, contagions can be manifested as negative externalities diffused 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. 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.
Contagions are named as such for their potential to spread quickly and (seemingly) unexpectedly. Global investment and cross-border trade make financial contagions more likely, especially among developing countries or emerging markets. In these markets, contagions are often exacerbated by asymmetric information, which results in both unsustainable investments and reactionary market downturns in response to the weakening of nearby or closely correlated markets. Larger and more established markets are better able to weather financial contagions than developing economies; despite neighboring most of the Asian countries afflicted by the crisis, China's markets emerged largely unscathed.
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.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 revolution and growth at the periphery of 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 cash into the continent. Investment in Latin America became a speculative bubble, and in 1825, the Bank of England, fearing massive gold outflows, raised its discount rate, which in turn sparked a stock market crash. The ensuing panic spread to continental Europe.
The global Great Depression, triggered by the 1929 U.S. stock market crash, remains an especially striking example of the effects of contagion in an integrated global economy.