What If Ireland Defaults? (9 page)

¹⁶
Although many sources mention contagion, no consensus has emerged on the precise definition of contagion (see, for example, Gallegati, Greenwald, Richiardi and Stiglitz, 2008). In the broadest sense, contagion involves spill-overs of economic events from one country to other countries (or, in the context of lending, from one borrower to other borrowers). A narrower view, more specific to crisis episodes, defines contagion as an increase in correlations among two countries in bad times or, in the words of Dornbusch, Park and Claessens (2000, p. 178), ‘a significant increase in cross-market linkages after a shock to an individual country, as measured by the degree to which asset prices or financial flows move together across markets relative to this co-movement in tranquil time.'

¹⁷
Bank decisions in anticipation of contagion can increase the level of systemic risk. For example, Acharya and Yorulmazer (2008) consider the lending decisions of banks affected by common as well as idiosyncratic shocks. If one bank fails, investors update their assessment of other banks. Investors are unable to tell if the bank failed for bank-specific or systemic reasons, so they become more reluctant to invest in the remaining banks. Anticipating such investor actions, banks try to minimise unfavourable information spill-overs of bank failures by investing in more highly correlated loans. Thus, the expectation of contagion causes banks to herd, which aggravates systemic risk and the magnitude of contagion occurring ex post. Nalebuff and Stiglitz (1983) examine the role of incentive conflicts in explaining herding.

¹⁸
See, for instance, Radner and Stiglitz (1984).

¹⁹
The general theory is set forth in Korinek (2008).

²⁰
Alternatively, if contagion occurred through ‘real' channels – Mexican purchases of Argentinean goods were enhanced as a result of exchange rate support, because real balance effects are more important than relative price effects – then the Mexican intervention could reduce spill-over effects. These effects did not play an important role in the discussions preceding most of the bailouts.

²¹
Stiglitz (2010c) uses a life cycle model to show that capital market liberalisation may actually reduce the scope for inter-temporal risk sharing, and thus lower the long-term present discounted value of expected utility.

²²
After each crisis of the 1980s and 1990s, policy makers identified a factor that seemed to be pivotal as the source of a crisis: an overvalued exchange rate, excessive public indebtedness, insufficient private savings, lack of transparency. But the analysis was ad hoc and had little predictive power. Mexico's problems in 1994 were markedly different from those of Latin America in the early 1980s. East Asian countries had high savings rates and low public indebtedness. The last set of countries to suffer from a financial crisis before the East Asian crisis were those of Scandinavia, generally viewed as the most transparent in the world. Furman and Stiglitz (1998) attempt to identify econometrically the factors that contribute to an economy's vulnerability to a financial crisis. Needless to say, their results confirm the lack of predictive power of the standard explanations of vulnerability to a crisis.

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