“Searching for international contagion in the 2008 financial crisis”

An interesting post at VoxEU by Andrew K. Rose and Mark M. Spiegel does a series of analyses looking to explain how the crisis evolved internationally, but the obvious connections don’t provide an answer:

The 2008 financial crisis is sometimes characterised as one where financial difficulties in the US spread to the rest of the world. But is there clear evidence of such international contagion? This column reports research indicating that neither financial nor trade linkages to the US help explain the cross-country incidence of the crisis. If anything, countries more exposed to the US seem to have fared better….

The case for contagion seems superficially clear. In this column, we discuss our recent research that probes more deeply into the 2008 crisis. In particular, we ask if countries that were more heavily exposed to toxic US assets suffered deeper losses during the crisis of 2008.

Surprisingly, our answer is negative – countries that had disproportionately high amounts of trade with the US in either financial or real markets did not experience more intense crises. If anything, countries more heavily exposed to the US seemed to fare better than others. And our results are robust; we examine over 40 different linkages between countries, in both trade and capital. This negative finding makes us sceptical of the ability of “early warning systems” – such as the one discussed in the de Larosiere Report (2009) – to successfully predict the incidence of future crises across both countries and time.

A bit of further thought shows why this finding (or lack thereof) is not as surprising as it might seem.

There is evidently more to the research than their high level summary at VoxEU shows, but it does not appear that they found data on foreign country exposure to toxic assets; indeed, that information would take an extraordinary amount of effort to compile. How do you identify, say, which foreign banks hold collateralized loan obligations or CDOs that have tanked? You need to find which ones have done badly (already a huge task, this information is available only from dealers) and then you have to trace back ownership. Thus the researchers presumably could not develop the most relevant data.

And using US asset exposures as a proxy for toxic asset exposures is wrongheaded. Consider Japan and China. Both are huge trade partners of the US, and both have holdings heavily weighed towards US Treasuries and agencies. They were not buyers of exotic debt instruments. I believe the same is true of Taiwan.

Another factor this analysis fails to capture is the vulnerability of a country to financial crises. Relevant metrics would probably be private debt to GDP and size of the financial sector relative to GDP. Switzerland has limited trade relationships to the US, but has an outsized banking sector, and one that held a lot of dollar denominated assets that turned out to be rotten funded by dollar liabilities. If a country has a banking crisis in a country’s own currency is comparatively manageable (albeit painful and costly). But when you have a large external debt, it creates all sorts of financial instability and the issue of solvency (even for a supposedly rock-solid country like Switzerland) becomes a real concern.

So I have no doubt that contagion factors can be found, but they may not lie in clean data sets that economists like to use in regression analyses.

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  1. Richard Kline

    To me, the focus on toxic assets in this analysis is misplaced. Not that it is a bad idea; it’s good to have the actual research. But toxic assets were not the source of global contagion in this crash. Oh in the US, the financial system was killed by a mulligatawny of ASB death cap fungi, sure. But it was a credit freeze in the shadow banking system which nailed the global economy. It will be some years before that assertion is verified by research with the actual data, but I’m confident it will be proven correct.

    The shadow banking system is a misnomer anyway. Call it ‘the Anglo-American Enterprise.’ Or the New York & London Co. What we really had was a plethora of off the books bookmakers and their coatroom cronies massively extending credit which had no basis in underlying assets. Liars’ loans, in other words. When principal enablers in the Anglo-American Enterprise locked upon on bad ASBs, credit provision froze in their backdoor enterprises. And by then, most sizeable players in the global financial system either had a piece of that action, assets on loan to that action, or anticipated credit provision from that action. I’m not blind to attendant speculative bubbles in places like Latvia and Spain, but these were fundamentally by-products of the activities of the NY & L Co., eddies in the profit stream; epiphenomena, in a word.

    It wasn’t bad assets that produced a global recession, it was bad actors, and liars intermediating credit that didn’t really exist. On the day somebody reached in the drawer for that faux cred it wasn’t there, and the music stopped.

    1. Skippy

      Careful thar Richard, or our trip will ensue before provsions are made. The offspring of John Laws thinking live today…eh.

      Skippy…The shadow banking system is a misnomer anyway. Call it ‘the Anglo-American Enterprise.’ Or the New York & London Co….Hay RK just say it out loud old man ‘Anglo American/London Trading Company’ an be done with it me thinks.

  2. yoganmahew

    The idea of contagion is, to my mind, largely a political construct. First it was subprime contagion which somehow caused a collapse in housing markets in other parts of the world that involved liar loans, no/low doc, subprime lending. Then it was a lend long, borrow short financial engineering credit crunch that spread from the US to, eh, other economies that had institutions that over-relied on short-term credit. The it was the collapse of Lehman’s that led to a collapse in confidence in similarly over-leveraged, poorly managed, risk-management-free zones…

    Spot the common feature? In each case a particular type of structure/lending practice/management practice collapsed in one part of the world before the same bad practice collapsed somewhere else.

    The point is not that there were direct measurable flows from one point to another, the point is that a collapse of a particular type of bad practice makes its continued use elsewhere untenable. It is like saying that heart disease due to obesity in one person causes death in most cases, therefore heart disease due to obesity in another person is likely to cause death in them too. This does not mean, however, that heart disease due to obesity is contagious.

  3. Siggy

    Searching for an international contagion will be a bit like waiting for Godot. The disease is not endemic, it is systemic in the form of a fiat currency that happens to be a world wide reserve currency. The dollar is the flea carrying the financial plague that infects the world economy.

    Posturing in China and elsewhere is signaling that the system is about to reject the dollar as a reserve currency. That is the real game and where our focus should be.

  4. smoody

    There were two conduits of contagion that are not trade-related: the yen-based carry trade and the USD-based carry trade. Neither of them have anything to do with ‘trade’ in the traditional sense. The USD-based carry trade was predominant in Eastern Europe and the Former Soviet Union. In Ukraine, for example, on 30.09.08, 80% of mortgages were USD-denominated. In Kazakhstan, 40% of bank liabilities were USD-denominated. In both cases, various forms of the carry trade are involved. The yen-based carry trade featured predominantly in speculation in WTI futures contracts and most of the world’s stock exchanges.

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