Monday, March 14, 2011

Kolb, Financial Contagion

Financial Contagion: The Viral Threat to the Wealth of Nations, edited by Robert W. Kolb (Wiley, 2011), is a collection of short papers written primarily by academics. Kolb’s lead chapter frames the problem quite elegantly. He distinguishes between contagion and an epidemic: contagion implies “a mechanism of transmission from one infected victim to other potential victims,” whereas in an epidemic the disease may either be contagious or may be spread by entities such as fleas or mosquitoes.

Kolb notes that “there is some danger of conflating contagion with the evidence of contagion. … According to many studies, a contagious episode in finance typically results in a particularly heightened correlation among the affected domains. … Although increased correlations may provide a method for identifying the occurrence of a contagious episode, the jump in correlations is hardly contagion per se.” (p. 4) Moreover, he suggests that there may be contagion without the “economic record that would statistically show the contagion that economists labor to discern.” Even though “there can be little doubt that Goldman Sachs and Morgan Stanley terminated their existence as investment banks as a direct result of the financial difficulties that took Lehman Brothers to oblivion and induced Merrill Lynch to throw itself into the arms of Bank of America,” there wasn’t enough time between these events to generate a statistically significant data series. (p. 9)

The book is divided into six parts and forty-six chapters ranging over theory, the Asian financial crisis, emerging markets, the financial crisis of 2007-09, regional contagion, and contagion within an economy. Although many authors rely on correlation analysis for their findings, there is little math in the book. That would be fine, but it’s symptomatic of a larger problem: most of the articles read like expanded abstracts.

Nonetheless, there are nuggets here and there, and for data geeks some staggering statistics. For instance, at the end of 2007 the foreign claims of Austrian reporting banks on Central, Eastern, and Southeastern Europe amounted to “more than 70 percent of Austria’s GDP and 26 percent of its banking system assets.” (pp. 302-303)

Financial Contagion: The Viral Threat to the Wealth of Nations (and I repeat the subtitle because, unlike 90% of the subtitles out there, I think this one is really good) covers a lot of territory. It is, of course, terribly important to analyze case histories to discover potential triggers, mechanisms of transmission, and viable ways to contain the damage of financial contagion. The problem is, as these articles amply demonstrate, that there’s always a new virus or a mutation of a former one lurking in some corner of the financial world. We don’t know what it is or where it is. And, even if we had some inkling, there’s almost never enough time to develop a financial “flu shot.”

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