Wednesday, 26 October 2011

Contagion defined

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome. 

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