On a recent road trip to a family event, I did an experiment while listening to Bloomberg for six hours in both directions. The various hosts were all interested in the topic of “contagion” and whether or not their guests thought we were in an artificial intelligence bubble. One pretty young host lamented that work was more fun when the market is going up.
All of the interviewees denied that there was an AI bubble. Of those who specifically addressed the issue of contagion in stock markets all of them denied its existence or even the possibility it could exist. Their tone was sharp or guarded and they tended to quickly turn to how diversified they were.
In contrast, Mario Inecco recently discussed the situation in the Japanese bond market and the yen carry trade, noting that “contagion” could spread dire consequences around the globe. For more coverage of this issue see the Minor Issue episode: Rushing the Financial Exits.
Contagion is the spreading of disease from one person to another usually based on close personal contact. In terms of markets, contagion refers to how problems in one company adversely impact all other similar companies and how such problems can adversely impact the entire economy and its stock markets.
In the wake of the covid pandemic scare, people might be particularly sensitive to the term contagion, but more poignantly our concern rests with the current “bull” market in stocks. It is currently 16 years and 5 months old and the S&P 500 Stock Market Index has risen 800 percent. The AI-heavy Nasdaq 100 index is up nearly twenty times its 2009 low point.
One thing that all the interviewees got wrong is the basic source of economic contagion which is government policy. In the absence of government policy, or policies, there is no contagion, in fact, the opposite is true. All economic contagion is the result of policy.
Let’s work through a couple of examples from the hypothetical free market:
- There are ten restaurants in town. One is badly run in some way or has some natural disadvantages such as a poor location and ends up going out of business. Is that going to adversely or positively affect the other nine restaurants? The other nine restaurants will now have access to more customers and trained workers such as cooks and waiters. They might be able to raise their prices a little and offer lower wage rates. It creates no disadvantages and it has some minor positive impacts, not contagion.
- There are a number of banks in the economy. One or more of the banks has taken on particularly risky loans that are then negatively impacted by changes in the economy that endanger depositors. A run on the bank by depositors ensues and the company is bankrupted. In the absence of policies tying all the banks together, depositors engage with more prudent and reputable banks. Those banks experience expanded deposits, and they can offer slightly lower rates on deposits. Again, the remaining firms are enriched from the “bad” bank leaving the business.
There is no contagion in the free market. Contagion is the result of government policy.
If we were to learn that 1,000 hospitals closed this year, no one would think that the population suddenly got much healthier, had fewer accidents and pregnancies, or that heart disease and cancer had been mysteriously cured. Rather, every knowledgeable person would immediately think that the government had somehow changed its policies regarding health industry subsidies, reimbursing health industry providers, or tax treatment for insurance premiums.
Likewise, if we were to learn this morning that Wal-Mart was going out of business, some of us would be in shock, but mom and pop competitors would smile, and some people would rush to buy stock in Target, Dollar Tree, and Costco.
Economic contagion requires government intervention that links and bonds companies and industries into some sort of dependency. The most noteworthy source of economic contagion is the interest rate policy of the Federal Reserve. When it artificially lowers interest rates by injecting large amounts of faux credit, it creates an expansion of borrowing by government, business and personal borrowing, such as home mortgages. A boom in the economy ensues, but eventually prices rise and the Fed and banks are forced to raise rates throughout the economy or risk currency devaluation.
Rapid and significant changes in interest rates and expanded borrowing and lending inevitably cause problems for lenders and borrowers alike. The Savings and Loan Crisis, the Housing Bubble, and Silicon Valley Bank, Signature Bank, and First Republic Bank all filed bankruptcy in the spring of 2023 because they were upside down on their balance sheets. They invested in long-term bonds during the covid interest rate bonanza and then could not pay the depositors higher interest rates as inflation and rates increased.
The Federal Reserve itself is upside down on its balance sheet with low-interest rate assets and higher rate liabilities. Fortunately for the Fed, they get an automatic taxpayer bailout for all their bad debts and lavish expenses. On the opposite side of the ledger are homeowners who all got ultra-low mortgages freezing up the housing market. They found themselves stranded, unable to move because of much higher housing prices and holding a cheap mortgage on their current address.
Obviously, contagion events are beyond prediction. However, with central banks working to undermine currency values and balance sheets so clearly out of whack, the global economy is fraught with the potential for economic contagion. The next time politicians and central bankers claim they need more power and more of your money to solve for contagion, remember that they are the cause of the problem, not the free market.
