August 17, 2007
Contagion & Vaccine
Posted by Gordon Smith

The word "contagion" has been popping up in news about financial markets lately. Look at Google News. Perhaps I am noticing this because I am "reading" (on my iPod) a fascinating book entitled The Great Influenza: The Epic Story of the Deadliest Plague In History, about the influenza pandemic of 1918. No one knows for sure how many people died from that virus, but current estimates range from 50 million to as many as 100 million.

Until today, many people had been arguing that the financial contagion of 2007 was confined to the financial markets. The "real economy" (another fashionable term) was said to be chugging along nicely. This led to articles like this one yesterday from the FT:

Most economists remain sanguine. After all, fundamental world growth prospects are strong, they say, and lower prices for risky assets could even make the economy more robust. Moreover, much of the market turmoil has erupted in financial spheres such as derivatives – which often appear to have a limited connection to the world of goods and services.

David Miles, chief UK economist of Morgan Stanley, for example, likens the complex financial products that are central to the current malaise to bets on a horse race. These bets can add up to an impressive figure – but they do not affect the outcome or the strength of the horse.

Similarly, he argues, in the real world it is the revenue-generating process of the economy in households and companies that matters, not the complex bets on this made between investors in sophisticated markets. Or, as Julian Jessop of Capital Economics puts it rather more directly: "People in financial markets always think they are more important than the real world."

Nevertheless, making a definitive judgment on the wider impact of the current turmoil is difficult, partly because the events unfolding in the financial sphere are highly complex – and still moving so quickly that policymakers often struggle to piece together what is going on.

This morning the Federal Reserve cut its discount rate by .5% and issued a statement acknowledging the potential link between the turmoil in the financial markets and the real economy: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

Markets -- especially bank stocks -- spiked dramatically on the news. But I haven't seen any references to interest rate cuts as a vaccine.

Economics | Bookmark

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