Financial contagion spreads from one country to another
Financial contagion is the transmission of economic and financial difficulties – usually from one country to another (although it can also happen between companies).
It is topical at the moment because economic troubles in Ireland are causing some investors to question if they want to continue investments in some other European countries. These investors are likely to fear factors that are causing financial woes in Ireland could be repeated elsewhere – even if the fears do not appear to stand up. In practical terms, it is said that such fears have led to drops in share markets in several countries over the last month or so and also led to higher interest rates for certain government loans. Bad news spreads in different ways
Financial contagion is not new.
In their influential 2009 book This Time is Different, writers Carmen Reinhart and Kenneth Rogoff look back at the history of financial crises over 800 years and identify two types of financial contagion. They describe the two types as the “slow burn” spillover and the “fast and furious”.
In the book, they say the “slow burn” typically follows an initially muted reaction to an event and is made up of “gradual and protracted” responses that together have major economic consequences. The “fast and furious”, however, can happen in hours or days.
Diversification protects against contagion
At the national and international level, federal financial support may be put in place in an attempt to reassure investors and halt contagion. At the personal level, diversification can help protect investors against the worst effects of contagion. This diversification might be achieved by ensuring savings and investments are spread geographically and across different asset classes.
The basic principles of diversification are explained in the eZonomics video The share market has risen. Is it too late to dive in?.