Contagion Thesis Once Derided Proven by Kristin ForbesJoshua Zumbrun
When Kristin Forbes sought tenure at the Massachusetts Institute of Technology early last decade, some colleagues said her research focus on financial contagion led to a dead end. Her reaction: Full speed ahead.
Forbes worked to safeguard global financial stability with then-U.S. Treasury Undersecretary John Taylor, became the youngest member ever on the White House Council of Economic Advisers and eventually won tenure at MIT. In August she presented the opening paper at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
“Kristin is one of the leaders in the empirical analysis of contagion,” said Roberto Rigobon, who, like Forbes, is a professor of economics at MIT’s Sloan School of Management in Cambridge, Massachusetts, and has co-written research with her on the topic. “Her papers are a tour de force for anyone interested in measuring” its “importance, existence and extent.”
Forbes, 42, says she still sees complacency over the risk that financial turmoil will spread beyond a single country, even with Europe’s struggle to curb its sovereign-debt crisis. Regulators aren’t doing enough to bolster preventative oversight, she said in an interview.
“Recently you’ve seen some softening of some of the regulatory requirements that are being talked about and some stepping back from some of the proposals,” Forbes said.
“There’s a trade-off obviously. In the middle of the crisis, having stricter capital requirements might delay a recovery, but it’s critically important for the long-term stability.”
Officials today may be tempted to bolster bank profitability by relaxing rules such as stress-test thresholds or by expanding the categories of assets that qualify toward liquidity buffers, Forbes said in the research she presented at Jackson Hole. Such loosening may backfire and “increase a country’s vulnerability to contagion.”
While requiring more capital may reduce the availability of credit, it also could offer nations “substantial benefits” by buffering against international panics. Tighter rules on bank reserves would reduce risks, acting on Forbes’s finding that “countries with more-leveraged banking systems are significantly more vulnerable.”
Forbes’ paper laid out the main pathways for the spread of a crisis, including trade, banks and financial institutions, along with investors who may be forced by losses in one country to sell assets in others. She also identified as a cause so-called “wake-up calls” -- when new information about a nation’s weaknesses compel a recalibration of risk beyond its borders.
Forbes said her research is especially relevant for the euro area today, and her Jackson Hole paper proposed prescriptions to alleviate that continent’s crisis.
Europe’s focus on sharing liabilities through the European Central Bank, European Stability Mechanism and European Financial Stability Facility may increase contagion risks as investors begin to question the solvency of countries providing bailout funds, she said.
Also, European policy makers confronting the risk of bank runs without a clear “lender of last resort” need to create a deposit-insurance system to “restore confidence” that funds will be accessible in the future, she wrote in her paper.
“Someone other than the Greek government needs to guarantee bank deposits in Greek banks,” she said in the interview.
ECB President Mario Draghi has pledged to do “whatever it takes” to end the euro crisis, and the 17 member nations are working to create a single banking supervisor. While bond yields have declined, the risk of bank runs in Europe persists, Forbes said.
“We’re in a lull right now, but it doesn’t mean we’re out of the storm,” Forbes said. “My sense is it’s not over. There’s such tremendous risks in so many countries.”
Her presentation at Jackson Hole drew praise.
“This is an important paper for the academic literature and will be widely cited,” said Franklin Allen, an economist at the University of Pennsylvania who was a discussant of her report. “It is also very important for policy makers.”
Forbes started on her path to Jackson Hole in 1997 while working toward a Ph.D. in economics at MIT, having graduated from Williams College in Williamstown, Massachusetts, with a degree in economics. A currency collapse in Thailand had sparked a crisis throughout East Asia, leading South Korea’s economy to shrink by 7 percent and Indonesia’s by 14 percent in 1998, and prompting intervention by the International Monetary Fund.
“Reading the papers where it came as such a surprise is what got me incredibly interested,” Forbes said. “Should we have seen it coming? Is there a way to track these things?”
One of her “major contributions” has been to clarify when declines in similar types of assets across nations signal a spreading crisis, said Menzie David Chinn, an economics professor at the University of Wisconsin in Madison.
“It is critical to understand whether events in one country have an impact on another, or whether both countries are being impacted by a common shock,” said Chinn, who has co-written research with Forbes on links among global markets.
Government officials will be less likely to wall off their financial system and more inclined to work with their foreign counterparts to calm markets after recognizing that assets have declined because of a common shock, Chinn said.
Forbes’s research caught the eye of Taylor, a professor at Stanford University in California known for a monetary-policy rule named after him. Taylor, who was Treasury undersecretary for international affairs, drafted Forbes to Washington in 2001 to help contain damage from a debt crisis in Argentina.
In a 1999 paper, Forbes and Rigobon had traced how Russia’s devaluation of the ruble in 1998 kindled a contagion that brought down Brazil’s stock market. In contrast, a collapse in U.S. stocks that triggers a similar tailspin in Canada isn’t necessarily an example of contagion through financial markets, they showed.
The U.S. and Canada have direct ties through trade, finance and geography, so “a crisis in the U.S. would be expected to have a strong, real impact on the Canadian economy,” Forbes and Rigobon said.
On Forbes’s first day at the Treasury, Argentina was receiving its final loan package before a cutoff from international lending. A plan to rein in its budget deficit was failing, money was flowing out of its banks and “it was clear the program wasn’t working,” she said.
Taylor and Forbes faced the challenge of determining if an Argentine debt default would trigger turmoil across Latin America. They bet it wouldn’t, and international finance weathered the peso’s collapse in 2002, Taylor said in an e-mail.
“The strategy worked because there was no contagion following the Argentina crisis, unlike there was following the Russian crisis three years earlier,” he wrote.
Forbes returned to MIT in 2002. While working toward tenure at the Sloan School, she faced a chorus of academic economists who believed the period of economic growth from the 1980s until early last decade -- known as the Great Moderation -- demonstrated that cross-border financial-market turmoil was no longer a threat.
“You really need a new topic; contagion is an issue of the past,” Forbes recalls being advised. MIT places a premium on research with real-world implications, and the prospect that financial crises would leap from country to country seemed remote as the global economy boomed.
Facing uncertain tenure prospects, Forbes left MIT for Washington again in 2003, becoming, at 33, the youngest economist ever to join the CEA. She focused on global issues under Chairman Greg Mankiw, a professor at Harvard University.
Washington’s interest in her talents wasn’t a matter of dispute, and she finally was awarded tenure while on leave at the CEA.
S.P. Kothari, a professor of management and the deputy dean at the Sloan School, recalls faculty discussions of Forbes’s research and whether contagion was a fruitful focus.
“There were some questions and some debates that took place, but the group quickly coalesced toward concluding she had done some extraordinary work,” he said.
Forbes left the CEA in 2005, returning to MIT. Since the U.S. subprime-mortgage market collapsed in 2007, sparking the worst global financial crisis since the Great Depression, the relevance of her chosen specialization hasn’t been questioned and she’s now the Jerome and Dorothy Lemelson Professor of Management and Global Economics.
Forbes is skilled at turning her economics research and insights into persuasive policy arguments, said Phillip Swagel, chief of the CEA staff when she was there.
She is “extremely effective on both substance and process,” Swagel said. “The latter is especially important. The people working on international-security issues look to ignore economists and economic analysis.”
Forbes “for sure” should be considered for another role in Washington, said Swagel, a University of Maryland professor and former Treasury assistant secretary for economic policy.
Forbes said she’s not sure she’d jump at an offer for another government job, though finance is the family vocation. Her husband is a fund manager at Fidelity Investments. They were married in 2000 at the Mount Washington Hotel in Bretton Woods, New Hampshire, site of the 1944 conference that established the rules and institutions behind the international monetary system, and have three children.
Government work is “a huge sacrifice, and I wouldn’t do it unless it’s an area I really felt I could help on,” she said.
After all of her research, Forbes said even the best policies won’t avert every banking calamity.
“What we probably could do is a better job preventing them from spiraling out of control,” she said.
That wasn’t the view of her MIT tenure advisers more than a decade ago.
“Don’t work on financial crises, don’t work on contagion,” they said, according to Forbes. “There’re not going to be anymore crises.”