Officials in Jackson Hole warned can limit, not escape contagion

JACKSON HOLE, Wyoming Fri Aug 31, 2012 3:30pm BST

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JACKSON HOLE, Wyoming (Reuters) - Nations fearing financial contagion from troubled neighbours can reduce the risk of infection by strengthening their banks, top monetary policymakers were told on Friday, but trade and cross-border investment links make full inosculation difficult.

The central bankers were attending the opening session of the annual Jackson Hole monetary policy symposium in Wyoming. Euro zone officials, battling a virulent sovereign debt crisis for two years, had been scheduled to take part but decided to stay home to prepare for a vital policy meeting next week.

The first academic paper presented to policymakers was on spotting and mitigating contagion, in which author Kristin Forbes, a professor at the Massachusetts Institute of Technology, likened the danger to that of cancer and argued the best defence was to bolster the banks.

"Most of the channels of contagion result from a healthy interdependence between countries in good times, as well as bad ... once a negative shock occurs in one country, there are no easy fixes for ending contagion in an integrated world."

Her work is timely. Concern the euro zone crisis could spill from the affected countries to the wider common currency bloc, and then across the Atlantic to the United States, is a top issue for policymakers and opinions remain deeply divided.

"A top priority should be to reduce leverage in banking systems," Forbes argued in her paper. "Policies to support financial institutions can play a significant role in reducing contagion and supporting economies after negative shocks."

Euro zone leaders have signed off on aid of up to 100 billion euros for troubled Spanish banks, and agreed to make the European Central Bank the top supervisor for the bloc's lenders.

This was viewed as a step toward a euro zone deposit guarantee program, which was the sort of backing that Forbes saw as one of the best ways to help the banking system.

Other options Forbes outlined included providing additional liquidity or loans to banks, recapitalizing them, or easing banking rules, although she argued that any short-term benefit from such a move would be outweighed by future costs.

Trade and cross-border investment portfolios were two other channels through which contagion spread, but Forbes argued it made little sense to try to limit either, as they both brought substantial benefits as well as costs.

Rather, she urged policymakers to encourage their countries to seek diversified trading partners, so if one partner suffered an economic hit, the lost export demand would be subdued.

She also argued they should ensure national investment portfolios were balanced, and public policy did not favour debt over equity, which automatically shares risks and is therefore a better stabilizer in troubled times.

"Just as there are legitimate protocols that can successfully fend of certain types of cancer, there are policies that can effectively fend off certain forms of contagion," Forbes wrote.

(Reporting By Alister Bull; Editing by Neil Stempleman and Tim Ahmann)

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