Knowledge and information pass between workers in different firms, formally and informally, as they trade with each other, so innovation is encouraged and productivity improves. Fourth, clustering tends to promote both competition and cooperation. Clusters tend therefore to increase productivity, drive innovation and stimulate the formation of new business. In these ways the clustering helps to create and reinforce the comparative advantage which drives trade. In the case of the financial industry some additional factors promote clustering. In the past of course there was the physical need to be close to the market places but it appears that the centripetal forces remain strong even in a world of electronic trading and video conferencing. There is a reputational advantage of locating in an established financial centre, which signals you are part of the Premier League. And in wholesale finance where the firms can be both sellers and buyers, business is  4  “City type” jobs in London include securities dealing, international banking, corporate finance, derivatives and foreign exchange activity, fund management (including hedge funds), specialist insurance (such as Lloyds) and professional services such as legal, accountancy and consultancy directly supporting other City jobs. They include jobs in Canary Wharf and in the West End as well as those in the Square Mile. 5  See, for example, Fujita, M, Krugman, P and Venables A.J, “The Spatial Economy: Cities, Regions and International Trade” MIT 2001. 2  BIS Review 29/2007  attracted to liquid markets, in cash and securities.
Since July, this applies also to some of the larger euro area countries such as Italy and even Germany. Moreover, the model indicates that the spillovers from Greece are persistent and are thus likely to dissipate only slowly in the presence of favourable developments. Another model co-authored by ECB staff assesses the effect of an increased probability of default of one country on the likelihood of default of other countries in the euro area, controlling inter alia for the fact that the degree of interconnectedness in the system changes over time.8 Let me emphasize that these default probabilities are estimated strictly on the basis of the CDS premiums quoted in the market, irrespective of whether the probabilities priced-in by the market are in line with the assessment made by official institutions. On the basis of historical CDS data, these models, for example, find that a default in Greece increases the probability of Portugal defaulting on its public debt by 30 percentage points. The results of this model may be interpreted as providing some indication of sovereign contagion effects from Greece to other euro area countries. In sum, both descriptive and model-based evidence point to the presence of significant sovereign contagion in the euro area. Moreover, these contagion pressures have recently intensified, as they have spread beyond the euro area’s periphery and have started to affect larger economies. Following up on my earlier discussion on the policy-relevance of contagion, policy makers need to address this.