Heeding contagion—preventing another economic crisis

The U.S. is unflinching in its optimism and ability to move forward after a crisis, such as the 2008 recession. And yet the drawback to this reflex is the ability to quickly forget what landed us in the situation to begin with. As our economy recovers, we potentially risk a growing complacency and inadequate financial oversight.

Just months ago, the country of Cyprus made global headlines as their banks’ ballooning assets grew far beyond what the country could support. Losing over 4.5 billion euros, the Cyprian banks tried to repair the damage by confiscating secure deposits, affecting the assets and the trust of investors throughout Europe and Russia and causing a ripple effect of investment withdrawals. The contagious effects of this crisis are a warning of how interconnected we are, and how one failed system could halt economic recovery elsewhere.

Financial Contagion is Real

MIT Sloan professors and economic experts Kristin Forbes and Roberto Rigobon have proven in their collective work that learning how financial shock in one country permeates the economic stratosphere of another can ultimately teach global financial institutions to communicate and collaborate to prevent a future crisis.

In their jointly authored paper, “Contagion in Latin America: Definitions, Measurement, and Policy Implications," Rigobon and Forbes trace how Russia’s devaluation of the ruble in 1998 kindled a contagion that brought down Brazil’s stock market. In contrast, they also showed how a collapse in U.S. stocks that triggers a similar tailspin in Canada isn’t necessarily an example of contagion through financial markets. But the U.S. and Canada do have direct ties through trade, finance, and geography, so “a crisis in the U.S. would be expected to have a strong, real impact on the Canadian economy,” Forbes and Rigobon said. Similarly, if Europe’s banking system began to collapse, this would most surely stall—and perhaps halt altogether—the U.S. economic recovery.

“You cannot entirely prevent another crisis, but you can prevent a crisis from spiraling out of control by learning from our past failures,” says Forbes, “and by setting up a system to monitor economic stress while ensuring that countries are working together rather than defensively isolating.”

In his May 10, 2013 speech, United States Federal Reserve Chairman Ben Bernanke clearly stated that monitoring the financial system is a priority and will require a new approach.

“Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential regulation and other policy tools that can be used to address them.” Bernanke said the Federal Reserve is setting up current systems to monitor U.S. financial systems.

Cyprus is our red flag: we have proof that contagion is real. We have a real opportunity to learn from our mistakes and find the balance between an austere approach (currently failing in Europe) that could halt all economic activity and the growing complacency that leads us to take no preventative action. If we can strike that balance, we can safely move beyond recovery and into prosperity.

Roberto Rigobon is a Professor of Applied Economics at MIT Sloan School of Management and teaches in the Strategies for Sustainable Business, and the Understanding Global Economics: Macroeconomics for Executives program, at MIT Sloan Executive Education.

Kristin Forbes

 is a Professor of Management and Global Economics at MIT Sloan School of Management.