Posts tagged with GUILLERMO CALVO

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Dubai Sneezed. Who Catches a Cold?

Sovereign debt crises can be contagious. Should we worry that the recent events in Dubai will also drag down other troubled economies?

To answer the question, first you have to understand why debt crises and defaults are contagious. Economists disagree about the answer, but they often cite a few potential explanations for why debt crises spread.

For one, investors who have lost big as a result of one default may need to suddenly cash out elsewhere.

“If you catch investors that are leveraged by surprise when something like this happens, then they will have to find liquidity somewhere, and they’ll start liquidating other assets,” said Guillermo Calvo, a professor of economics, international and public affairs at Columbia.

This type of contagion is likely if a country is somehow “systemically important” — if, say, lots of major investors are exposed to its debt. The other countries in these investors’ portfolios may suddenly find money hard to come by.

“It’s a domino effect,” Professor Calvo said.

Contagion can also happen because investor confidence has been shaken in a particular asset class: One tiny (supposedly systemically-unimportant) country’s default could cause investors to worry about problems in other similar countries. Read more…