Next, I shall review recent evidence of contagion phenomena across European sovereigns. The third part of my speech will deal with how the European Central Bank has responded to these developments; and the fourth part with the ultimate key responsibilities pertaining to domestic fiscal authorities in this area and the need for strengthened governance structures. Financial contagion and public policy Since the writings of Walter Bagehot financial contagion has become an issue that is discussed widely in policy, market and academic research circles.2 Taking a broad  1  W. Bagehot (1873), Lombard Street – A Description of the Money Market, pp. 129ff. Emphases by the speaker. 2  See, for example, the following surveys on the issue: G. Kaufman (1994), “Bank contagion: A review of the theory and evidence”, Journal of Financial Services Research, 7; E.P. Davis (1995), Debt, Financial Fragility and Systemic Risk, Clarendon Press, 2nd ed. ; O. de Bandt and P. Hartmann (2000), “Systemic risk: A survey”, ECB Working Paper, no. 35, November; S. Claessens and K. Forbes (eds., 2001), International Financial Contagion, Kluwer Academic Publishers; ECB (2005), “Financial market contagion”, Financial Stability Review, December; ECB (2009), “The concept of systemic risk”, Financial Stability Review,  BIS central bankers’ speeches  1  perspective embracing different views and studies, contagion could be defined as a situation in which instability in a specific financial market, institution or country is transmitted to one or several other markets, institutions or countries.
A first characteristic of contagion is that the spread of instability would usually not happen without an initial trigger event – which often appears to be a relatively contained event. A second characteristic is that the transmission of instability is in some way abnormal, for example, in terms of its speed, strength or scope. Though spillovers are to be expected in an interconnected financial system, contagion is distinct in that it often reflects a market failure and a dangerously amplified transmission of instability. The underlying market failure consists of the fact that contagion often involves externalities.3 As a result, the private costs of the initial financial market failure, that is the costs to the actor triggering contagion, are lower than the social costs. In the specific case of the sovereign debt crisis in Europe, the trigger could, for example, be that a country in a precarious fiscal situation does not seriously implement the necessary fiscal consolidation measures. This could lead interest rates on this particular country’s government debt to rise and could in turn also constrain economic growth in that country. This is what I call the “private costs” of such behaviour. Although in this case the lack of fiscal discipline is something which is strictly related to one country, this circumstance may still lead volatile financial markets to also lower their expectations about fiscal consolidation efforts in other countries. As a result, those other countries also begin to face costs in terms of significantly increased interest rates on their government debt.