Guest post by Alan Cunningham
Economic contagions can be extremely damaging to any society. Remaining unchecked, an economic disaster within one industry or business sector could easily take down other important industries and sectors necessary to any functioning society or nation-state.
An economic contagion is defined basically as, “an economic crisis [that spreads] from one market or region to another and can occur at both a domestic or international level”. For a more expanded definition of the subject, this economic or financial contagion, is “a situation in which a shock that initially affects only a few financial institutions spreads, or spills over, to the rest of the financial system and the economy, subsequently infecting the financial systems and economies of other countries…Like a physical disease, contagious financial panics hurt not just those directly affected, but the entire system. But beyond tangible financial connections, contagion can be thought of as excess correlation [with time, the correlation between the properties such as magnitudes or variations of frequency occurs when only random relationships should exist], or asset co-movements over and above the amount justified by economic fundamentals”. As one can see, financial contagion can be very deadly and incapacitating to a nation-state, much like how a real, physical disease can cause a person to be very ill or die.
An example of an economic contagion that almost everyone will recall was the collapse of Lehman Brothers. Originally a dry goods store that came about in 1848, Lehman Brothers turned to “commodities trading and brokerage services,” surviving the Great Depression, industry bankruptcies, and capital shortages and collapses. As the company entered the 2000s, Lehman Brothers engaged in widespread investment in, “mortgage-backed securities (MBS) and collateral debt obligations (CDOs),” resulting in massive profits with the firm, “[seeing] a 10% increase from 2005,” and, “reporting record profits every year from 2005 to 2007”. These commodities formed the backbone of the housing market and, eventually, would prove to be the downfall of the housing bubble and send the global financial market into a recession. Eventually, after accumulating 85 billion dollars worth of these investments, stocks fell sharply in late 2007 and then again by 48% in March of 2008. While the Fed and the Treasury were unable to help Lehman with government funds, they did pressure Lehman, “to find a buyer as Bear Sterns had done,” and while there was some effort made by both Lehman Brothers CEO Dick Fuld and the federal government to try and solve the crisis, the end result was the two primary buyers of Lehman pulling out of the deal, resulting in the firm’s declaring bankruptcy in September of 2008. With Lehman Brothers and Bear Sterns, this was one of the first shocks in the economic system, before the final spreading of the contagion to AIG, the international financial giant which (while saved by the federal government) would have resulted in the global economy collapsing.
Economic/financial contagion is a very serious problem that can occur in the financial system. During the COVID-19 pandemic, the entire globe has suffered an economic contagion of various kinds.
When the virus first struck, “Stock markets plunged…due to the shocking news of the virus spreading around the world”. It has also been documented that in various locations around the world, including the United States and China, “the daily growth in the total confirmed cases and total cases of death caused by COVID-19 both have significant negative effects on stock returns across all companies”. However, the COVID-19 pandemic has been much more different than previous contagions.
According to The FinReg Blog of Duke University’s School of Law, “…it is possible to timestamp the crisis and identify its main catalyst… in 2020 we did not observe such typical early warning signals; rather, the main catalyst of the contagion was the COVID-19 virus itself. While there are a range of views, we can attempt to model of a clear timeline of the virus’s spread across regions and countries, while recording relevant government responses to the pandemic… COVID-19 differs from previous episodes of financial contagion in the speed of the transmission of the crisis and recovery. We can expect both quicker escalation of the COVID-19 crisis and quicker recovery than previous crises… the COVID-19 pandemic demonstrates heterogeneity in reactions and recovery patterns not only across asset classes, but also within them” while also mentioning that social media has played a significant role in advancing the crisis, altering the stock market, and formulating public opinion.
With the signing of President Biden’s bipartisan infrastructure bill which aims to “funnel billions to states and local governments to upgrade outdated roads, bridges, transit systems and more”, the ability to combat infrastructure problems and better protect against economic contagions will surely be assisted.
Solving or mitigating financial contagions can come in the form of both private and public actions, with private action constituting, “enhanced institutional capital requirements…new private liquidity requirements…and loss imposing resolution procedures,” while public actions come in the form of, “unlimited public liquidity support for, or an explicit guarantee of, short-term non-deposit liabilities issued by financial institutions, deployed either in the form of a central bank lender-of-last-resort or as a publicly administered insurance regime modeled on deposit insurance”. While these are effective solutions to normal economic contagions, these solutions may not be as helpful when considering the COVID-19 pandemic.
In a 2020 Harvard Business Review article, multiple economists and members of the private financial industry discuss the economic fallout of COVID-19 while also providing some potential solutions to these issues, writing that, naturally “a vaccine would reduce the need for social distancing and thus relax the policy’s chokehold on the global economy” while noting that, from an economic perspective, “policy innovation also will have to occur. For example, central banks operate so-called “discount windows” that provide unlimited short-term finance to ensure liquidity problems don’t break the banking system. What is needed now, today, is a “real economy discount window” that can also deliver unlimited liquidity to sound households and firms. The emerging policy landscape includes many worthwhile ideas. Among those are “bridge loans” that offer zero-interest loans to households and firms for the duration of the crisis and a generous repayment period; a moratorium on mortgage payments for residential and commercial borrowers; or using bank regulators to lean on banks to provide finance and to rework terms on existing loans”.
In spite of all this, the authors write that any implementation of an economic policy to assist in anti-COVID-19 measures would need to be applied in an “agile and efficient execution”.
In the event of another economic contagion caused by a contagious disease like COVID-19, it would be beneficial for governments, corporations, and private industry organizations to better protect their economies and financial services against these diseases and deadly pathogens.
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