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The Takeaways: MIT Sloan Faculty Members Offer Their Perspectives (continued)

Containing contagion: “There is no replacement for good macro-fundamentals”
Kristin Forbes
November 1, 2012

Contagion, a phenomenon where financial tumult in one country or region spreads to another country, is now a fact of life. The globalization of finance has, in many ways, made contagion inevitable. The world has become much more integrated through trade, investors, and banks, and these ties have caused countries’ financial markets to move together more closely during good times and bad.

While exposure to the international economy is hard to completely avoid, some types of contagion are temporary and even avoidable. According to my recent research, which was presented at the annual meeting of central bankers at Jackson Hole, Wyoming, this summer, one lesson from Europe’s financial crisis is that an over-leveraged banking system increases vulnerability to contagion. In fact, leverage appears to be a more significant determinant of country vulnerability than the total international exposure of a country’s banking system. This suggests that limiting leverage and implementing strict capital requirements should be considered as a policy to decrease the risk of contagion in the future.

There is a lesson here for foresighted U.S. policymakers. The best approach to minimizing the threat of contagion is through fundamental structural reforms before a negative shock occurs and financial infection from a troubled foreign economy is imminent. A top priority for Washington lawmakers should be to reduce leverage in the banking system and reduce overall government debt levels. Policymakers should also avoid policies that give preferential treatment to debt over equity, as well as support portfolio investors’ efforts to diversify and invest abroad.

MIT Sloan Experts Blog
Kristin Forbes is the Jerome and Dorothy Lemelson Professor of Management

Fiona Murray and Bill Aulet on why all jobs are not created equal...
“Small business creation is an important part of job creation, but it is only a part of what is needed to create large transformations in the economy. Innovation-driven companies—that start small but have the aspiration and potential to grow—will ultimately generate the new jobs and exports that economies need to drive prosperity.”

“Not All Jobs Are Created Equal,”
The Boston Globe, October 17, 2012
Fiona Murray is the David Sarnoff Professor of Management of Technology and the Faculty Director of the Martin Trust Center for MIT Entrepreneurship

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