European Financial Contagion Woes Affect Dow Jones
Yesterday, I opened my news feed to see some disastrous news for stockholders- another big dip in the stock market. Why this time? Italy. Last month, their prime minister promised to step down, but it wasn’t enough to quell the fears of those within the country. Bonds surged past the crisis level (7%) to hit 7.42% and a default is on the horizon. This makes investors nervous, as usual, and the Dow Jones started to plummet.
Last week, the eyes of the world were watching Greece. Political turmoil has been the cause there; until last week, the socialist party was dominant in their parliamentary government; then, the government was on the brink of collapse and talks are still going on as to what the future holds.
Government instability really changes things.
There are a couple of odd advantage to this, though. All of the economic turmoil in the EU has been helpful to the US dollar as the Euro has significantly lost value. It has also caused oil prices to drop, which will be reflected in gas prices in the coming days.
Wait a minute, didn’t the third quarter end on a positive note? Wasn’t there speculation that we may be starting to get out of the financial mess that we’ve been in for the last decade? There was; then Greece and Italy happened.
Greece and Italy have created fear of something called financial contagion. In short, financial contagion is when financial issues within one or two small countries start a domino effect, spreading like a disease among multiple countries that may or may not have been healthy prior to the spread of financial disaster.
Why does this happen? There are a few theories:
Currency Crises- The most accepted theory of financial contagion causality is that countries who depend on the same currencies are all affected when one of those countries starts to fail financially. In the case of the Euro and US dollar, they are used frequently in exchange rates, and therefore if they struggle, they affect currencies around the world.
Interconnected Financial Institutions- Financial globalization, according to this theory, is the core of the spread of financial contagion. Banks borrow and buy from one another, and if any of the financial institutions start to struggle, it holds the potential to harm the others.
Changes in Investor Psychology- For the same reason that the stock market rises and falls, financial contagions may be spread. Sometimes, investors will see one country start to fail (for example, Portugal and Ireland) and assume that any country that is using the Euro will have the same issue. They then fail to invest in companies that may be in countries that share the same currency. It may also be a general frame of mind; investors may be looking at Europe and saying “if they fall apart, why won’t we do the same thing?” They then start to bail out of their investments as quickly as possible.
The perception of financial contagion is a scary thing for any investor. Investor panic always ends in days like today. Will it be better tomorrow? Who knows, but keep your eye on it. Until Monday, spend smart, save smart!
