If the Portuguese or Italian governments were to tumble into a serious debt crisis, how would this affect sovereign and bank risk across the rest of the eurozone and US? Or how would European banks and insurers react if American institutions were hurt by a US rate rise?
These are questions that many investors might ponder this summer. After all, the word “feedback loop” has been sowing fear ever since the 2008 crisis showed how interconnected the modern financial system has become. And with trading liquidity having shrivelled in recent months – and volatility having risen – the issues of contagion and feedback loops are raising unease again.
But while that “c” word – contagion – provokes alarm, what is also striking is just how little we understand the complex network of modern financial flows. Of course, much economic research has been produced since 2008 analysing how asset classes, or individual countries – or continents – are performing. But if you compare the field of financial economics to the hard sciences, there is still surprisingly little “joined up” analysis of finance as a single interconnected entity. Or as Doyne Farmer, a former physicist who is now an Oxford economics professor, says: “We spend more on polar research than we do on studying economic systems . . . which is very strange given the impact [of finance on our lives].”