The Global Consequences of Financial Contagion
In a world where financial problems don’t respect borders, how do you coordinate an international response?
The Great Recession began in the United States in 2008. By the end of that year, twelve of the United States’ thirteen most important financial institutions, many of which did extensive business overseas, were on the brink of failure. Within five years, the crisis had fully contaminated the global economy, with nearly all of Europe’s major financial firms requiring bailouts. The magnitude of the crisis illustrates the extent to which the financial system is globally interconnected—and why that’s risky.
The global financial system is more interconnected than ever.
Over the past several decades, the financial industry has globalized and became more concentrated. The operations of various institutions—hedge funds, commercial banks, investment banks, and others—have gradually become more intertwined. Commercial and investment banks lend to one another, which links them directly. And financial institutions invest in common assets, a practice that links them indirectly. At the same time, distinctions among different types of financial institutions have blurred, due in large part to the 1999 repeal of the Great Depression–era Glass-Steagall Act, which separated the activities of commercial and investment banking operations in the United States. After the repeal of Glass-Steagall, commercial and investment banking operations no longer had to be conducted separately; banks got bigger and even more intricately connected.
The industry is also concentrated: about twenty large complex financial institutions with vast operations—think JPMorgan Chase or Deutsche Bank—dominate global finance; according to the International Monetary Fund (IMF), just eighteen of these heavyweights were responsible for over half of the losses reported by banks and insurance companies around the world during the economic crisis of 2008.
This interconnectivity is supposed to make the global economy more efficient and effective, but it’s also inherently risky because a problem in one institution can quickly spread to others. When that happens, it’s called contagion—the same word used to describe a disease spreading quickly from people in close contact. Because the global economy is like a web, domestic economic problems in one country can quickly become domestic economic problems in another. Or, as was the case in 2008, they can catalyze a worldwide economic crash.
But while the global economy is interconnected, there’s no global governance, no global currency, and no global monetary policy.
Countries (or sometimes regions, as with EU countries) maintain their own currencies and their own monetary policies. Central banks around the world set various policies to meet their goals, such as keeping inflation to a certain percentage annually.
Of course, countries do cooperate on economic issues (they trade with each other and coordinate in times of crisis), and international financial institutions like the World Bank and the IMF exist, but neither one is a global central bank. The World Bank gives loans and grants to low- and middle-income countries so that they can economically develop; the IMF aims to keep the international monetary system stable by monitoring countries’ monetary policies and sometimes providing loans. The World Bank and the IMF focus on their specific mandates and don’t function as a global central bank for a simple reason: there is no global currency.
In fact, when world leaders convened in Bretton Woods, New Hampshire, in 1944 to establish an international monetary system and create the World Bank and the IMF, their objective was not to create a unified system that every country in the world would use. Instead, these leaders—with the United States playing a central role—sought to establish a system in which countries would retain control over their own currencies and policies, and still be able to easily trade and invest abroad. The U.S. economy was large and strong at the time, so the U.S. dollar became the de facto global currency of this new system, used by governments around the globe.
Because of the dollar’s special status, the United States exerts massive influence on the global economy.
The United States is home to less than 5 percent of the world’s population but generates almost 25 percent of global gross domestic product (GDP), the sum of all final goods and services the world produces in a given time frame. The United States is also the largest importer and second-largest exporter in the world; in 2019, U.S. imports and exports totaled more than $4 trillion. Beyond the sheer size of the U.S. economy, some of the world’s largest financial institutions are American banks with global operations, making the economic health of the United States vital to international prosperity.
What happens in the U.S. economy doesn’t just stay there.
In the 1990s, U.S. banks began giving mortgages to subprime borrowers, people who were more likely to default on (i.e., not have the means to repay) their loans. To lend this money, mortgage issuers themselves borrowed money from investors. This practice had a domino effect. As people became increasingly unable to pay back their mortgages, banks began to run short of the money needed to repay their own investors. By 2008, the pattern of banks granting subprime mortgages and people defaulting on loans snowballed beyond U.S. borders and created an economic crisis that rippled through the intricate web connecting banks and other financial institutions around the world: banks that trade with, borrow from, and lend to one another every day.
The web connecting banks and other financial institutions is what spread the contagion.
In general, places with more ties to the global economy, like European countries, felt the crisis most quickly and acutely. Asia did not experience negative growth rates, but its exports dropped and the speed of the region’s economic growth slowed. Africa’s relative isolation from the global economy (and the increasing direction of its exports toward Asia rather than Europe) allowed many African countries to avoid the worst of the recession. Nevertheless, many African and South American countries, which depend on exports of commodities such as oil, felt the effects of the global recession through declines in commodity prices and global trade.
Because no single institution can prescribe a response to a global crisis like 2008, responses were varied.
Different countries enacted different policies to respond to the crisis depending on their capabilities and priorities. In the United States, the government responded to the financial crisis with bank bailouts, tax cuts, and direct government spending to boost the economy.
In Europe, many governments pursued austerity, or deep cuts to social spending in areas like health care and education. As Greece, Iceland, Ireland, Portugal, and Spain became infected by the global financial crisis, the EU and the IMF bailed these countries out. But the bailouts often came with conditions that the recipient countries cut their spending. Proponents of austerity argued that it was a necessary step to decrease debt, but its opponents maintained that austerity did nothing to resolve the financial crisis and simply deepened the public’s misery. In 2018, research from the Institute of International Finance showed austerity policies resulted in a 10 percent reduction in GDP growth in Europe compared to the United States.
The international response to 2008 showed what global coordination could look like—and what its limitations would be.
In 2008 and 2009, leaders from the twenty largest economies, known as the Group of Twenty (G20), met to discuss the crisis. They agreed to lower interest rates, increase government spending to boost their domestic economies, help countries that were in the worst shape, pursue regulatory reforms, and keep international financial institutions like the World Bank and IMF well resourced. In addition, the U.S. Federal Reserve gave U.S. dollars to central banks around the world via a monetary tool known as a swap line. With U.S. dollars, these banks had access to the main currency used in international transactions.
The cooperation of G20 leadership was essential but it wasn’t enough. No matter how much countries cooperate economically, and how carefully and frequently international institutions intervene, countries or regions are themselves ultimately responsible for their own currencies and economic policies. The health of the global economy still heavily depends on what these countries and regions decide to do.