The Economics Of Contagion: 5 Ways The PIIGS Virus Spreads From Country To Country


RBS’ Jacques Cailloux is out with an excellent (albeit very gloomy) report on the European situation called Euro Area Faces Breakpoint, essentially arguing that things are only getting worse, leaders are still just screwing up, and that you should still short the peripheral countries.

One interesting section looks at the economics of “contagion,” a term that’s used a lot to describe the cascading crises hitting country after country.

The note identifies 5 basic channels through which the crisis spreads:

  • The ratings channel: The ratings agencies may seem irrelevant, but they’re actually not (yet). Nobody really trades based on a downgrade, but they do trade ahead of downgrades, and since the ratings agencies are behind the curve, there are opportunities to basically short countries in anticipation of downgrades.
  • The risk management channel: Cross-asset correlations have become significantly tighter over the past year, in part because investors take a big picture view of exposures, lumping bonds and equities in the same basket, moving in and out at the same time.
  • The liquidity channel: Simple, when liquidity dries up, in dries up for everyone.
  • Herding: Again, very straightforward.
  • The uncertainty channel: This is really where the failure of leadership comes into play. A series of goalpostchanges and micro-solutions has made it impossible to figure out what comes next in Europe. Hence: dump everything.

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