Too embarrassed to ask: what is contagion?

Most of us probably know what “contagion” means in a biological sense – particularly after 2020 brought it home to us in a very visceral manner.  But it’s also a term that crops up in financial markets. And just as “contagion” almost always spells bad news in the real world, it’s also not a term you want to hear in market news. 

Global economies and financial markets are arguably more interconnected in the modern era, than at any other point in history. This has lots of benefits. But this interdependence also means that problems which erupt in one corner of the globe can have unexpected consequences elsewhere. 

As a result, a financial crisis which at first seems contained in one market or sector, can spread – just like a virus – and potentially overwhelm apparently unrelated markets elsewhere. In other words, there is the risk of “contagion”. 

How does financial market contagion generally spread? Debt is a major source of contagion, and also one of its main vectors. 

It’s simple when you think about it. Say a friend owes you £100. You need to get it back so that you can go to the pub that night. But when you go to collect, it turns out that he used it to take a punt on a dodgy cryptocurrency and now has no money. As a result, you can’t go to the pub, and the landlord doesn’t get your £100. That’s contagion.

To take a real-world example, the 2008 financial crisis spread globally because ownership of debt linked to US mortgages was far more widespread than most investors had realised. When US house prices fell and that debt collapsed in value, it caused panic as investors sold indiscriminately, unsure of who they could trust.

But while falling US house prices may have been the trigger for the crisis, the real problem was that financial institutions generally were over-leveraged. In other words, they had borrowed too much money, so it only took a small drop in the value of any assets they owned to render them insolvent. 

This then fed into a wider crisis because bankrupt banks sold assets and stopped lending money to anyone else, which in turn caused pain in the wider economy.

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