How to Prevent Euro Zone Contagion

by Kristina Peterson

Wall Street Journal
August 31, 2012

European Central Bank President Mario Draghi canceled his plans this week to attend the Kansas City Federal Reserve’s economic symposium in Jackson Hole, Wyo. But central bankers and academics gathering are discussing the crisis he faces.

Preventing the financial turmoil in one country from spreading to others — a process called contagion — requires different measures in the euro zone than in other regions, finds Kristin Forbes, an economics professor at Massachusetts Institute of Technology‘s Sloan School of Management, in a paper to be presented at the conference on Friday.

Because the 17 countries in the euro zone share a currency and a central bank, they can’t individually adjust to shocks outside their borders through currency devaluation or monetary policy. That makes it more important for euro-zone countries to maintain flexible economies that can adjust quickly, she writes. That also may provide a little more justification for taking policy actions to help stop a chain of bad events that could unleash widespread damage, she writes. European leaders have been arguing for many years over what to do to stop the spread of rising government bond yields, capital flight, bank losses and other financial problems through the region.

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