Contagion

What is 'Contagion'

Contagion is the spread of market changes or disturbances from one regional market to others. Contagion can refer to the diffusion of either economic booms or economic crises throughout a geographic region.

BREAKING DOWN 'Contagion'

Contagions occur both globally and domestically, but they have become more prominent phenomena as the global economy has grown and economies within certain geographic regions have become more correlated with one another. Contagion is seen by many scholars as being primarily symptomatic of global market interdependence.

Usually associated with a financial crisis, 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 assets quickly and confidence in other large banks drops accordingly. In principle, the same process occurs when international markets crash, but  Globally, cross-border investment and trade can resultant in quick crashes of closely correlated regional currencies, as in the 1997 crisis when the Thai baht collapsed and market shocks 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, 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 makes 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, caused by the 1929 U.S. stock market crash, remains an especially recent and striking example of the effects of contagion on an integrated global economy.