Reveal, depress, destroy: Three types of contagion

The term ‘contagion’ is used quite a bit in the financial press, but what does it actually mean?  There are at least three very different types of contagion, each with its own policy implications:

1.  An economic crisis in one country might reveal a weakness that was not previously apparent to the international investment community.  Thus in the late 1990s, the gradual rise of China and the strengthening US dollar was slowly weakening the position of export-oriented nations in Southeast Asia, which had fixed their currencies to the US dollar and also accumulated dollar-denominated debts.  When Thailand got into trouble in mid-1997, investors looked around and noticed similarities in places like Malaysia and Indonesia.  It wasn’t so much that Thailand directly caused problems in those countries (in the way a US recession might directly cause problems for Canada); rather it revealed weaknesses that were already there.

2.  A financial crisis in a big country might depress the global Wicksellian equilibrium real interest rate.  For example, the US housing bust and banking crisis of 2007-08 triggered a global recession.  By itself, this doesn’t necessarily cause problems in other countries.  But if the foreign country is already at the zero bound (Japan), or if the foreign central bank is too slow to cut interest rates (ECB), then a lower global equilibrium interest rate might lead to tighter money in other countries.  Here I would say that the US triggered the Great Recession, but the Fed, ECB and BOJ jointly caused the Great Recession.

Similarly, under an international gold standard, the hoarding of gold in one country can depress nominal spending in other countries.  Indeed gold hoarding by the US and France was a principal cause of the Great Depression.

3.  A financial crisis in one country can affect other nations if they are linked via a fixed exchange rate regime or a single currency.  Consider Greece, which comprises less than 2% of eurozone GDP.  Fears that Greece might have to leave the eurozone caused significant stress in other Mediterranean nations.  If one country were to exit, investors might expect this to lead to an eventual breakup of the entire eurozone.  That would trigger a banking crisis, and would also lead major debtor nations such as Italy to default on their huge public debts.  This is why a small country like Greece could have such a big impact on eurozone asset markets; investors feared that a Grexit would destroy the eurozone.

So far, Turkey looks like it fits the “reveal” template best.  The greater the extent to which Turkey is viewed as a special case reflecting local conditions, the smaller the contagion effect.  If Turkey becomes seen as emblematic of much of the developing world, then contagion is more likely.



19 Responses to “Reveal, depress, destroy: Three types of contagion”

  1. Gravatar of Justin Justin
    14. August 2018 at 13:45

    Wow a macro post!

    The financial press have been talking about “contagion” spreading from Turkey, without any definition of what contagion actually is. I think they really do imagine some amorphous “badness” that spreads, country to country, sort of like how “confidence” mysteriously falls.

    Turkey lets NGDP go a little wild, inflation moves from 7% toward 12%, lira falls. Trump lays on a few tariffs to punish Erdogan for imprisoning a possible CIA asset involved in the failed Gulenist coup, and for Turkey making sovereign decisions about defense procurement rather than buying over priced US junk, lira falls a lot more. You could also argue Erdogan’s nepotism isn’t particularly encouraging from a long run RGDP perspective but the point is these are all Turkey-specific issues. How does it knock-on?

    One would hope the ECB is up to the task if this does start to stress European banks, they really should be able to weather a substantial rise in bad loans at this point though.

  2. Gravatar of B Cole B Cole
    14. August 2018 at 17:12

    There is something fishy going on in Turkey. Moreover, they are a neighbor of Greece and about to get fried.

  3. Gravatar of ChrisA ChrisA
    14. August 2018 at 23:11

    On a related note compare the real gdp growth between Greece and Turkey over the last ten years. A great example of how too tight ngdp growth is vastly worse than a bit of inflation.

  4. Gravatar of Tom Tom
    15. August 2018 at 07:54

    On point 1, would the revealing of a previously unknown/unappreciated investment risk impact market expectations of future NGDP in the similar economies? It seems to me, that if a similar economy to the crisis country had a competent and fast reacting central bank, then NGDP expectations should be unaffected by the revelation of new investment risks. For an economy similar to the crisis country, is the “contagion” in point 1 a change in stock prices due to increased riskiness of future corporate cash flows or is there an increased riskiness in overall economic stability due to a change in NGDP expectations?

  5. Gravatar of ssumner ssumner
    15. August 2018 at 08:55

    Tom, In case one, it wasn’t primarily an NGDP shock, it was a real shock.

  6. Gravatar of bill bill
    15. August 2018 at 12:05

    If Turkey is a potential “reveal” case, who are the likely “reveal-ees”? And what is being revealed?

  7. Gravatar of Willy2 Willy2
    15. August 2018 at 13:18

    – The reason Turkey is so important is that it is running a Current Account Deficit of over 6% of GDP.
    – Turkish companies have borrowed heavily in EUR/USD/??? because interest rates in those currencies were lower than in turkish liras. And that has become a problem now the lira has gone down against the EUR and USD.
    – Reports say that banks in especially Italy have lent to those turkish companies.
    – I use the “Wicksellian interest theory” as toilet paper. It’s that usefull.

  8. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    15. August 2018 at 23:05

    I feel that present Turkey’s social choice is different from the other developing countries.

  9. Gravatar of Jim Jim
    16. August 2018 at 09:19


    I had two unrelated questions:

    1) Imagine a world where real GDP is growing at 10% long term. With a 5% NGDP target, what would happen? Prices would fall every year by 5%? with wage stickiness, wouldn’t this be a problem? You mentioned a few years ago, that the post civil war era was something akin to this, but was just curious if you would see any problems with constantly lower prices..

    2) in this 10% RGDP world, would you favor a higher NGDP growth target of 10% to 15%?

  10. Gravatar of ssumner ssumner
    16. August 2018 at 10:08

    Bill, I haven’t followed developing countries closely enough to have an opinion on that question. Time will tell.

    Jim, Wages follow NGDP growth (per worker), not inflation, so wage stickiness would not be a problem as long as NGDP per worker was growing at a decent rate, say above 2%.

  11. Gravatar of Jim Jim
    16. August 2018 at 11:50


    What if productivity growth was 10% a year (so 0% population growth in example above)? I know its unrealistic but just trying to work examples out in my head. NGDP per worker would be -5% and wage stickiness would be an issue?

    Just wondering if general if wage stickiness can be overcome. Does 5-10 years of falling wages eventually ingrain in peoples heads that nominal wage cuts are OK as long as real wages are increasing?

  12. Gravatar of Jim Jim
    16. August 2018 at 12:12

    Or I guess stated differently, how much of an issue would wage stickiness be if the NGDP growth target was set at -5%?

    I know it’s wildly unrealistic, just curious…

  13. Gravatar of Scott Sumner Scott Sumner
    16. August 2018 at 16:20

    Jim, I think minus 5% would be a big problem, at least in the short to medium run.

  14. Gravatar of Inklet Inklet
    17. August 2018 at 00:23

    “Wages follow NGDP growth (per worker), not inflation,”

    I’ve never read this before and I can’t seem to find this idea on google.

    Could you point where we could find more information about the subject, maybe a post about it?

  15. Gravatar of Benjamin Cole Benjamin Cole
    17. August 2018 at 01:34

    OT but fun headline:

    Chinese Media Warns of Japan’s Plaza Accord Lessons
    Bloomberg-2 hours ago
    As China and the U.S. prepare to resume trade talks, a Chinese state-run media outlet has reminded its readers of Japan’s economic plight after it agreed to U.S. …..


    I think the People’s Bank of China may be the best central bank on the planet right now. And think about it—when the globe sank into deep recession in 2008, China kept growing…..

    BTW, the PBOC reports to the State Council in China, and is not regarded as an independent central bank….

  16. Gravatar of Ryan Ryan
    17. August 2018 at 04:06

    I’m a new reader of this blog. When you say the Fed caused the great recession is that because they did not save Lehman?

  17. Gravatar of bill bill
    17. August 2018 at 04:32

    Dang! I was wondering who to bet against. Lol.

  18. Gravatar of ssumner ssumner
    17. August 2018 at 07:52

    Inklet, Think of it this way:

    1. Wages tend to follow total aggregate compensation per worker—right?

    2. Total compensation per worker tends to follow NGDP per worker, as total compensation’s share of NGDP is pretty stable over time.

    Back in the late 1990s and early 2000s, China’s inflation was near zero, but wages rose fast because NGDP rose fast.

    Ryan, No, they had a tight money policy that caused NGDP to fall.

    Bill, Always remember–markets are efficient.

  19. Gravatar of bill bill
    18. August 2018 at 09:58

    Understand. I have only bought index funds for the last 30 years.

Leave a Reply