Each year at the Jackson Hole meeting, the Fed hears presentations from five researchers on the biggest issues in the market.
Of course, Europe was a major topic this year – and the Fed heard the latest research on how financial contagions can spread globally.
The idea is, as the world’s economies become more closely related, the easier it is for a negative shock from one country to spread to another. And considering that markets across countries have become more correlated by nearly every measure, it’s a serious issue.
So as we become more exposed to economic influences from other countries, what can we do to stop contagion from spreading?
That leads to my troubling takeaway from Jackson Hole this year: The United States has no control over keeping contagions from washing up on our shores – including the European debt crisis.
How the European Debt Contagion Could Spread
A paper by Kristin Forbes of MIT explains four ways a contagion spreads. For our purposes, we only need to focus on three…
- Through trade. For instance, a decline in the U.S. economy will weaken demand for Chinese exports, thereby spreading to the Chinese economy.
- Through banks. When European banks have liquidity concerns, the global supply of credit is reduced – slowing growth across the board.
- Through investors. When stocks decline, investors may need to reclaim funds invested in other countries.
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Contagions spread through multiple means and produce different effects. And most contagions spread through several of the above modes at once.
Generally speaking, however, the biggest culprit is banks. It turns out that tracking the levels of leverage and capital requirements is the best predictor of a contagion spreading.
For instance, reducing leverage and maintaining strict capital requirements can prevent the effect of contagions in the future. And switching more financing from debt to equity investments would seriously decrease the instability of the global economy.
Europe is no exception. Its contagion is spreading in all four ways, but banking is the biggest threat. Why? Because there isn’t a central bank (or lender of last resort) that can be held accountable and calm fears.
The European Central Bank (ECB) is filling that role to some degree, but it doesn’t have the same relationship a truly sovereign central bank would.
Keep in mind that at Wall Street Daily we still don’t expect to see a global calamity arise from the European debt situation. But in the end, the problem isn’t a slowdown in the European economy. It’s the potential contagion spreading through the bank channel.
And since we can’t isolate ourselves from the contagion, it’s up to the ECB and the solvent nations of the European Union to save our butts.
Ahead of the tape,