Contagion Meaning in Economics

Contagion Definition

A contagion refers to a situation in which the economic and financial shocks in one country are spread in other countries as well. This contagion phenomenon occurs because the economies of countries throughout the world, are interconnected and interdependent due to globalisation, international trade and shared financial systems. The economic and financial crisis happens in one country and its affects are widespread in many countries throughout the globe. For example, Russia and Ukraine are two major suppliers of food and energy. The Russia-Ukraine war has affected many parts of the world, including the Europe in terms of food insecurity, rising energy prices and inflation. Financial and economic contagion is the side effect of globalisation.

Think of contagion like the spread of a viral disease. If one person is sick, the nearby people can also catch the disease and become sick. Similarly, in the financial world, if one country faces a financial crisis, it can quickly affect the nearby countries leading to a domino effect of financial problems affecting many countries around the world. 

Understanding Contagion

In biology and medical science, contagion means the spread of a disease among people by close contact. For example, the spread of COVID-19 from China to the rest of the world is a recent example of contagion. In economics and finance, contagion is the rapid spread of economic changes from one country to the other parts of the world, just like the spread of a viral disease. 

Let’s understand contagion by taking a simple example. Suppose that there is rumour that a bank is going to be bankrupt soon. How will people react to this rumour? The depositors may start to withdraw their money from the bank as soon as possible. The bank may face liquidity problem due to a sudden rise in the demand for cash leaving that bank on the verge of bankruptcy. If the fear among people is contagious, not only the very bank in our example will be negatively affected, but this financial crisis can also spread throughout the whole banking system of the country. This is an example of contagion at national level. Similarly, financial contagion can occur at international level.

How do Contagions Spread?

Let’s now understand how financial contagions spread. Although, it depends on many factors, including the type of contagion, the general concept of a contagion spread is as follows:

Localised Starting Point

The start of a contagion is localised, which means that it occurs in one particular geographical area or one asset category. For example, the Asian financial crisis of 1997 started in Thailand as an issue of currency devaluation.

Spread to Nearby Locations

From the starting point, the contagion starts spreading to other nearby geographical locations that are in close proximity to the starting location. The spread may hit other asset categories as well. It is just like a ripple or an earthquake spreading away from its epicentre. For example, the Asian financial crisis of 1997 was spread throughout Southeast Asia after starting in Thailand.

Widespread Financial Distress

Finally, the contagion is widespread, which means that it reaches geographical locations which are at a greater distance from the starting point. For example, the Asian financial crisis of 1997 was spread throughout Asia and some parts of Europe.

Contagion Examples

Contagion can happen at both national and international levels. It can affect products or services, capital goods, and labour across markets that are connected by financial systems. Some examples of financial contagion are the 1997 Asian financial markets crises, the COVID-19 pandemic, the financial crises of 2007–2008, and the Great Depression.

Sensitivity of Economies to Financial Contagion

When markets are weak, an acute financial crisis can not only affect one market but also spread to other markets, affecting the overall economy. Those markets that totally rely on debt are relatively weak and less flexible due to factors such as a specific good, a smooth entry or exit of new firms, or conditions that hinder adjustments of price and quantity and adjustments to business models.

As banks and markets evolve towards cross-border loans, which lead to economic stability and growth, this may cause financial contagion. There is a high chance of vulnerability when banks provide short-term debt facilities. Those countries that have a better capitalised banking system provide long-term loans to debtors that allow them to prove less vulnerable to financial contagion.

Causes of Financial Contagion

The following are the main causes of financial contagion:

Credit Crunch

A credit crunch is the shortage of money available for loans. In today’s world, when economic markets are interconnected, a shock or crisis in one economic market will trigger an asset selloff in global economic markets, which will lead to a credit crunch.

State Lines

After all, all the channels through which financial shocks are transferred between global markets go beyond state lines. The international financial markets, trade links, and banking centres are those channels that are linked through domestic and global securities.

For example, in the 2007–2008 financial crisis, the shock or economic crisis in the U.S. mortgage markets was transferred to the whole global market through bank linkages. Asian currency crises were due to trade links. The Thai government attempts to protect economic competitiveness between global markets by devaluing its currencies.

Interconnected Markets

Domestic and global economic markets are interconnected. So, a crisis in the domestic market can also affect the global market as well. The products that many consumers use are substitutes and complementary goods, which mean that they are linked. The inputs of many businesses can also be substitutes or compliments to one another. Labour and capital that a company uses can also be used in multiple industries or markets.

In this way, the economies of these businesses rely on financial institutions to regulate a smooth flow of products or services from one economy to another. Any kind of disruption in the economy can cause disruption throughout the country and in the balance sheet of its financial institutions. This damage will trigger the sale of assets.

Effects of Financial Contagion

The following are some negative effects of financial contagion that affect global economic markets:

Economic Effects

The most common effect of a financial contagion is a loss of confidence in the financial system. When depositors feel a lack of confidence in banks due to financial contagion, this may cause banks to run. When thousands of account holders want their money back, this will cause a bank failure. This leads to reduced investment, increased unemployment and slow economic growth. Another negative effect of financial contagion is that it causes volatility, which triggers asset selloffs and capitulation. A contagion can also lead to increased pressure on government for economic reforms. 

Social Effects

A financial contagion can have many social effects, including poverty, income inequality and social tensions. There may also be price fluctuations and uncertainties, which may affect all classes of society alike. There may also be housing problems and family strain on account of the spread of a financial contagion. 

International Effects

When contagions spread, they have the potential to affect many countries. For example, the global financial crisis of 2007–2008 negatively affected the economies of many countries across the world. 

Solution to Financial Contagion

Haemorrhaging is the loss of a large amount of money over a period of time due to financial crises, and it is difficult to stop it from happening. Regulatory or other financial authorities first need to fix the problem of haemorrhage, which costs many years to cover up a stock crisis in an economic market. 

In the United States, the Federal Reserve Board, the Federal Reserve Chair, and the Federal Deposit Insurance Corporation (FDIC) provide guidance and maintain the rules and regulations by imposing policies during any financial crises. When financial crises occur, just like the Great Depression, the Federal Deposit Insurance Corporation (FDIC) insures the bank deposits of its citizens of more than $250,000. 

For example, in 2008, the United States Congress passed a bill for $700 billion as a Troubled Asset Relief Programme (TARP) in the case of the Financial Crises of 2007–2008. Additionally, the Federal Reserve started a series of quantitative easing strategies and set interest rates to zero for a period of six years, from 2008 to 2014, so that banks could operate in a normal way and lend money comfortably.

In March 2023, a bank-term funding programme (BTFP) was created in view of the collapse of Silicon Valley Bank. This programme offers loans to depository institutions, banks, credit unions, and other savings associations for a one-year period in order to meet their depository obligations. This programme was made to provide additional funding to the bank so that it can fulfil its depositor’s needs.

Conclusion

In conclusion, financial contagion is an economic crisis that affects one market and then spreads to other markets, causing economic damage to those markets as well. Weak markets are easily affected by financial crises. This concept first came into existence after the financial crises of 2007–2008. We have all seen the COVID-19 pandemic, which affects almost all the economies in the world.