Talks of contagion risk, despite having a brief respite earlier this year, are back stronger than ever. With Italy dominating the news, the new risk is that a new European domino is threatening to topple the others over.
Paolo Manasse and Giulio Trigilia give a particularly insightful look into what these contagion fears actually look like.
The authors find that over 80 percent of the total variance in the Eurozone CDS market can be explained by general Eurozone risk. This is a sharp increase from less than 60 percent at the beginning of the year. Their conclusion: “once again markets are bundling EZ members as one in terms of risk.”
Despite an earlier uncoupling of country-specific risks – especially those of Greece, Portugal and Ireland – the markets are once again pricing in a convergence of these countries´ risks relative to general CDS spreads. Stated differently, over the summer months these countries accounted for only small statistical portions of total CDS spreads. The tides have turned of late, with the result that these countries are increasingly affecting the general risk of the Eurozone market. Their conclusion: the risk of systemic contagion is increasing.
Finally, the two authors look at the correlation between the new contagion culprit de jour – Italy – and other Eurozone member states. The bilateral correlation between Italy and all countries (save Germany) is between 0.99 and 1. In other words, 5-year CDS spreads are moving in almost perfect lockstep between the affected European countries. The authors’ conclusion: little diversification can be achieved by investing in different Eurozone countries.
By all three measures the authors make the claim or allude to the conclusion that because markets are moving with high degrees of correlation, the risk of contagion is high. Such an analysis ignores the definition of what “contagion” means.
As I pointed out previously, contagion in the general sense (and also the financial sense) only occurs when one event affects an otherwise innocent bystander. Two questions arise. How do we know that the innocent bystander was actually affected by the “contagious” party? What would it take to be considered fully “innocent”?
The two authors in question actually answer the first question, at least as it pertains to Italy, claiming “Italy’s problems are homemade – contagion is a sideshow.” Indeed, Italy’s problems are more the result of unsustainable domestic policies coupled with weak growth then they have to do with contagion from Greece (or elsewhere). This in part explains why markets gave only the weakest rally with the exit of Berlusconi. The problems are largely already sunk, and it is now difficult to quickly revive growth or limit promised expenditures.
On the other hand, what does it take for one to be innocent, and thus susceptible to contagion. If I walk down the street, and someone with a contagious disease sneezes on me, I am surely the object of contagion. I had no connection to the individual prior to the event. Indeed, there was no way that I could have known that they were to sneeze on me (perhaps they did so only accidentally, but it would make no difference). But what if my friend with a communicable disease is bed-ridden at home, and so I decide to pay him a visit. By entering his sickly house I knowingly place myself at risk. When I return home and get sick there is no use in blaming my sick friend for my unfortunate health. I did it to myself.
The countries of Europe are sick, and the Eurozone as a whole is highly contagious. But there is no way that we can say that those parties inside the system are innocent. Holding Greek debt, or Italian debt, or bonds of a bank that holds these debts, these are all acts that remove your supposed ¨innocence¨. These are all activities that put you at risk because of the connection between the risky activity that you are undertaking, and the party that you are undertaking it with.
If I don’t want to get sick, I don’t enter my sick friend’s house. If I don’t want to be affected by the Eurozone’s sickness, I don’t invest in the guilty parties’ bonds. I also don’t associate with people who do so – banks, insurance companies, or investment funds.
By labeling the crisis as one of contagion, attention is drawn away from the real causes. Highly risky financing activities fueled by an easy-money credit policy over the last decade are now bearing their rotten fruits. Profligate European governments now find their revenues unable to cover their promised expenditures. There are specific causes to this crisis, and specific culpable parties. Chalking market misfortunes up to “contagion” risk obfuscates the true causes, and hinders meaningful analysis of workable solutions.