Are Financial Crises Becoming Increasingly More Contagious?

What

is the Historical Evidence on Contagion?

Michael D. Bordo
Rutgers University and NBER
Antu Panini Murshid
Rutgers University and World Bank
August 14, 2000

This paper is based on an earlier paper, “The International Transmission of Financial Crises before World
War II: Was there Contagion?” prepared for the ADB/IMF/World Bank conference on “International
Financial Contagion,” Washington D.C., February, 2000. The authors are indebted to the conference
participants for their valuable comments and criticisms. The authors are also indebted to Debajyoti
Chakrabarty, Simon Evenett and Peter Montiel for constructive criticisms and comments, as well as Larry
Neal and Jong Woo Kim for suggestions about data sources and help obtaining data. Finally we are deeply
indebted to Jean Skidmore for patient research assistance and to Patricia Kerster for data work.
 Are Financial Crises Becoming Increasingly More Contagious? What is the

Historical Evidence on Contagion?

Abstract

The scope and severity of the recent series of financial crises to hit Latin America and East Asia has helped
to crystallize a belief, that in this new era of global economic markets, "good health," in the sense of sound
economic policies, can no longer ensure a nation's immunity from crises. Yet from a historical perspective,
the recent spate of crises, as measured by their scope and severity, is nothing new. In the century and a half
preceding World War II, there were numerous financial crises, some of which dwarfed the recent batch in
both severity and scope.

In this paper we examine the evidence of contagion during episodes of volatility during the pre-World War
I period as well as, the interwar and contrast our findings with evidence from the recent crises in Asia and
Latin America.

Using weekly data on bond prices and interest rates, we investigate the extent to which bilateral cross-
market correlations rise following the onset of a crisis. After correcting for heteroscedasticity, ala Forbes
and Rigobon (1998, 1999), we find little evidence of significant increases in cross-market correlations in
either the earlier regimes or in the more recent period. Moreover, there is no indication that financial crises
are any more contagious today than in the past.

We then shift our focus away from contagion stemming from specific crises and ask the more general
question, Is the overall extent of comovement greater during turbulent periods? We use principle
components analysis to assess the extent of comovement across all markets as well as within various
groups of markets, prior to, and after the onset of a crisis. Countries are grouped into regions, as well as
into advanced and emerging countries. There is little evidence to suggest that cross-country linkages are
tighter during more turbulent periods for the recent period. There is, however, some evidence of stronger
comovement during periods of instability in earlier regimes.

2
1. Introduction

The recent series of financial crises in the emerging markets, the Mexican crisis of 1994-
95 and the Asian crisis of 1997-98, closely followed by the devaluations of the Ruble and
the Real, have been decried for their virulence and their far-reaching effects beyond their
epicenters. Certainly these recent batch of crises have been particularly severe.1 Yet,
that crises can spread across international borders should not, of its own accord, be
surprising; it is merely a reflection of the interdependence of cross-country fortunes in the
presence of real and identifiable channels of transmission. Moreover, in the face of
macroeconomic imbalances and or structural weaknesses, crises, when they arrive,
should not be surprising, rather they are a reflection of the unsound economic policies
and inefficiencies fostered in an underdeveloped financial infrastructure. However, as
the October 1997 crash on the Hong Kong Exchange demonstrated, good fundamentals
alone cannot insulate a country from the effects of financial contagion.2 Moreover, the
sharp drops on the Brazilian exchange and the eventual devaluation of the Real,
following the Russian crisis are difficult to attribute to bad fundamentals or cross-country
linkages. 3

These recent crises have led to the view that financial crises can spread across
international borders like a contagious disease, unless curtailed by heavy lending by the
international financial institutions. Indeed the scope and severity of the recent batch of
crises is such, that it has helped crystallize a belief that financial crises, in this new era of

1
Bordo and Eichengreen (1999) assess the severity of the recent financial crises and compare them to
crises in the prewar and interwar periods. They find the average drop in output following a crisis, in a
sample of ten emerging countries, in the post Bretton Woods period, to be greater than the average drop in
output following a crisis in any other period this century.
2
That Hong Kong was not insulated from the effects of the Asian crisis is a reflection of intra-regional ties,
however, unlike many of its neighbors, there was little evidence of the type of corruption and cronyism that
have often been associated with the Asian crisis. By contrast the regulatory supervision over the banking
system was much stricter. Moreover, government budgets in Hong Kong were conservative.
3
Whereas we can attribute Hong Kong’s woes to regional ties, it is difficult to establish any real linkages
that can justify the events that transpired in Brazil as an implication of the crisis in Russia. The heavy
losses inflicted on a handful of highly leveraged investors following the Russian crisis, causing some of
them to liquidate their positions in Brazil, is one possible channel of transmission. However, it is not clear
that this alone could explain why the Brazilian stock market plummeted and eventually forced the
government to devalue the currency. In a recent study of the contagion from Russia to Brazil, Baig and
Goldfajn (1999), conclude that, “the data does not seem to reflect a compensatory liquidation of assets

3
globalization, are becoming increasingly more contagious.4 Yet from an historical
perspective the recent spate of international financial crises is nothing new. In the
century and a half preceding World War II there were numerous international financial
crises, some of which dwarfed the recent batch in both severity and scope.

In this paper we assess the evidence of contagion in the pre-World War II period and
contrast this with our findings for the more recent period. Using weekly data on the price
of sovereign debt for nine countries, we focus on two crises from the pre-World War I era
– the Baring Crisis in 1890 and the US banking crisis in 1893.5 The earlier of these two
episodes of instability, had its origins in the financial crisis in Argentina early in 1890.
The events there had ramifications for the House of Baring, which triggered a financial
crisis in London that eventually fed back to Latin America. We examine the interesting
dynamics of that year, by focusing on the first half and the latter half of that year
separately. That is we first investigate the extent of contagion stemming from the earlier
Argentine crisis, and then examine the contagion following from the troubles of Baring
Brothers later that year.

For the interwar, we utilize weekly data on bond prices of foreign government bonds that
were traded on the NYSE. 6 Specifically, we focus on the contagion stemming from the
crash on the NYSE in 1929, from the UK following the devaluation of sterling in 1931,
and from the US following the devaluation of the dollar in 1933. For the recent period
we examine the two recent crises to hit Latin America and East Asia. Specifically, we
focus on the episodes of volatility following the devaluation of the peso in December,
1994, and the devaluation of baht in July, 1997. For this period, we utilize a weekly data
set on short-term interest rates. Our coverage is varied. For the six-month period piror to

story by international investors.” They conclude that if there was contagion from Russia to Brazil, the most
likely source of this contagion was from the offshore Brady market.
4
Following the recent series of financial crises, the volatile nature of private capital flows has become
evident. This has led many to propose policy safeguards against sudden reversals of capital flows. Some
have gone further and questioned the long terms benefits of capital flow liberalization. Jagdish Bhagwati
(1998) argued that the case for fully-fledged capital flow liberalization was not as strong as for trade
liberalization.
5
The countries in our sample are Argentina, Belgium, Brazil, Canada, Chile, France, the Netherlands, the
UK and the US. Source: The Economist, Weekly Commercial Times, various issues.

4
and after the collapse of the peso, our data spans 15 countries.7 This number increases to
23, for the period spanning the devaluation of the baht.8

In section 2 of this paper, we provide an historical account of numerous international

financial crises in the nineteenth and twentieth centuries and attempt to identify the
possible channels of transmission that could have dictated the spread of these crises. We
identify several key channels of transmission, which include linkages through
international trade, through lending from the core to the peripheral countries, through
arbitrage in short-term securities markets, and through gold flows. With this narrative as
background, combined with the aid of a chronology of financial crises (banking and
currency crises) for 21 countries,9 both advanced and emerging, in section 3, we examine
the empirical evidence on contagion by examining the behavior of the correlation
coefficient in the period surrounding a crisis.

In section 4, we change our perspective from specific episodes of volatility and the
contagion stemming from specific countries, and focus instead on the extent of
comovement across markets during periods of volatility in general. That is we ask the
question, Do financial variables across markets exhibit greater comovement during
turbulent periods? Hence we are less interested in whether markets exhibited higher
correlations with Thailand following the crisis there, or with Mexico following the peso's
collapse, and more concerned with the extent of comovement, across all markets, during
periods of volatility. We use principle components analysis to analyze this issue. Our
analysis reveals evidence of significant comovement across markets during both periods
of turmoil and periods of relative stability. We then take this analysis one step further

6
The countries in our sample are: Argentina, Belgium, Brazil, Canada, Chile, Denmark, Finland, France,
Germany, Italy, the Netherlands, Sweden, Switzerland, the U.K. and the U.S. Source: Commercial and
Financial Chronicles, various issues.
7
The countries in our sample are Australia, Canada, Denmark, France, Germany, Hong Kong, Indonesia,
Japan, Malaysia, Portugal, Singapore, Thailand, the U.K. and the U.S. Source: Reuters.
8
The countries in our sample are Australia, Brazil, Canada, Denmark, Finland, France, Germany, Greece,
Hong Kong, Indonesia, Italy, Japan, Malaysia, Mexico, Philippines, Portugal, Singapore, Spain, Sweden,
Switzerland, Thailand, the U.K. and the U.S. Source: Reuters.
9
The chronology of crisis, by Bordo and Eichengreen (1999), was constructed for the following countries:
Argentina, Australia, Belgium, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, Italy,
Japan, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, U.K., USA. The countries in our
sample are a subset of these 21 countries for which we were able to obtain weekly data on bond price
movements.

5
and examine the evidence of comovements within various groups of countries. Countries
are grouped into regional clusters and into advanced and emerging. We use principle
components analysis in order to investigate the extent of comovement within these
various clusters. For the interwar, we find some evidence of greater comovement
following the sterling and dollar devaluations. However, for the recent period, the
evidence of tighter cross-market linkages, within various regions of countries or within
the set of advanced or the set of emerging countries, is weak. Section 5 concludes.

6
2. Historical Perspectives on the International Transmission of Financial Crises

2.1 The Incidence of International Financial Crises

The recent series of crises in emerging markets, the Mexican crisis of 1994-95 and the
“tequila spillovers” to Latin American and other countries, the Asian crisis of 1997-98
and its “spillovers” to Brazil and Russia, has led to the view that financial crises (both
currency and banking crises) tend to spread across countries like a contagious disease
unless they are curtailed by vigorous international intervention. From an historical
perspective the recent spate of international financial crises is nothing new. In the
century and a half preceding World War II there were numerous international financial
crises, some of which dwarfed the recent batch in both severity and scope. Below we
discuss their incidence and evolution.

The nineteenth century had periodic international financial crises in virtually every
decade since 1825. Kindleberger (1986a) Appendix B presents a chronology going back
to the seventeenth century. His focus was primarily on showing a common incidence of
crises in the core countries of Europe and the U.S. Morgenstern (1959) displays a
chronology of stock market panics for European countries and the U.S. from 1880-1939
showing a high degree of cross-country coherence. Thorp’s (1926) Business Annals is
also a source showing common patterns of banking panics, stock market crashes, and
financial stress in 17 countries. Bordo (1986) focused on 4 European countries (U.K.,
France, Germany, Sweden) and the U.S. and Canada 1870-1939. His chronologies of
financial crises, banking panics, and stock market crashes highlighted the international
coincidence of these events and of several empirical measures of financial stress under
the classical gold standard and gold exchange standards. Recently Bordo and
Eichengreen (1999) compiled a chronology of banking and currency crises based on
historical narratives and a currency crisis index for 21 countries from 1880-1973. (See
Figure 1). This chronology is complemented with measures of the economic impact of
crises. Again a pattern of recurrent international crises is evident.

7
From this literature we learn that there were periodic financial crises in a large number of
countries over the past century and a half. The key crisis years before World War II were
the following: 1825, 1837-38, 1847, 1857, 1866, 1873, 1890-93, 1907-1908, 1914, 1920-
21, and 1929-33. In the postwar Bretton Woods regime, although there were currency
crises in advanced countries associated with adherence to the adjustable peg exchange
rate regime, there were no banking crises and the crises observed had relatively minor
economic effects. For the period beginning in 1880 for which we have sufficient data to
assess the economic impact of crises, the evidence from Bordo and Eichengreen (1999)
suggests that the severity of crises in emerging countries before 1914 may not have been
as great as that observed in today’s emerging countries and that it is the incidence of twin
currency and banking crises today that may account for the different experiences.

2.2 Patterns of Transmission

From the historical literature we can discern a number of explanations for the
international transmission of crises. These include linkages through international trade,
through lending from the core to peripheral countries, through arbitrage in short-term
securities markets, stock markets, and commodities markets between advanced countries,
and through gold flows and the money supply and psychological factors independent of
the other channels.

All of the pre-World War II crises occurred under variants of the gold standard. This has
two important implications. First, most countries adhering to gold convertibility after
1880 were tightly linked to each other by the fixed exchange rates of their gold parities
and the absence of serious impediments to the flow of goods and capital. This facilitated
the transmission of shocks, including financial crises, between countries. Second, these
international crises often occurred in periods of deflation when, under the self-regulating
operation of the commodity theory of money which in the long-run drives the price level
for the gold standard world, an excess demand for monetary gold created an environment

8
of monetary stringency and financial distress (Bordo and Wheelock 1998, Bordo,
Duekker, Wheelock 1999).
Within this context the record suggests a number of geographical patterns of crisis
transmission. The dominant mechanism was between the advanced countries of Europe,
with crises often originating in Great Britain, the center of the international financial
system, and from the core to the periphery countries of North America, Latin America,
and the rest of the world. However, crises also originated in the periphery and especially
in the U.S., which spread to Europe and then back to the periphery. Below we document
some of the more important episodes.

2.3 Episodes of International Financial Crises

1825. The crisis of 1825 is often viewed as the first international financial crisis. The
liberation of Latin America in the early 1820s led to a massive inflow of capital from
Britain to finance the exploitation of gold and silver mines and of sovereign loans to the
newly independent republics. It also led to an export boom. These foreign influences
combined with the rapid growth of the new industries of the industrial revolution and
liberal monetary expansion in the years after the Napoleonic wars led to a speculative
mania on the London Stock Exchange (Gayer, Rostow, and Schwartz 1953, Neal 1998,
Bordo 1998). A growing trade imbalance and a drain on the Bank of England’s gold
reserves led the Bank to raise its discount rate in the summer. A stock market crash in
October triggered a banking panic in December, which spread to the continent. The
Bank, concerned over its own reserves, did not act quickly enough to allay the panic,
which resulted in numerous bankruptcies and a recession. The crisis spread to Latin
America as the overseas loans were cut off, a decline in investment and exports reduced
tax revenues and led to sovereign debt defaults across the region. It took three decades
before the debts were renegotiated and capital flows in Latin American resumed
(Marichal 1989).

1836-38. This crisis was primarily an Anglo-American affair. In 1836, the Bank of
England began raising Bank rate in response to an external gold drain caused by poor

9
corn harvests and capital flows to the U.S. to finance a boom in cotton lands. The
resultant stock market crash in December 1836, spread to Paris. The effects on the U.S.
were dramatic. A reduction in lending to cotton factors in New Orleans sparked a
banking panic there that spread through the correspondent banking system to New York.
The resultant nationwide panic led to suspension of specie payments in May 1837 that
lasted close to a year. The crisis was transmitted through capital market linkages and
through specie outflows and their effects on money supply (Temin 1969, Levy-Leboyer
1982, Huffman and Lothian 1984).

1847. This crisis, primarily a European affair, was triggered by the collapse of a
speculative boom in railroad shares in London. As in earlier episodes, the British balance
of trade turned negative. The Bank reacted to declining gold reserves by raising its
discount rate. This ended the boom, caused prices to fall and triggered a major banking
panic, which ended only with an announcement that the Chancellor of the Exchequer had
signed a letter temporarily suspending the Bank Charter Act, thereby allowing the Bank
to issue more notes than would be covered by its gold reserves (Clapham 1945,
Dornbusch and Frenkel 1984). According to Kindleberger (1986a), the crisis spread to
Germany and Holland in the next year through international banking channels.

1857. This crisis began in the U.S. A railroad stock boom fueled by the recently
discovered gold fields in California and British capital, collapsed in August 1857. This
led to the banking panic of 1857 with widespread bank failures. This crisis spread to
England in the fall and, like the 1847 event, was ended in November by a Treasury letter.
From England the crisis spread to the continent, with a serious panic in Hamburg in
December. According to Kindleberger, the crisis was also felt in South America, South
Africa and the Far East.

1873. The crisis of 1873 is viewed as a major international crisis. The run-up to the
crisis was a lending boom in Latin America to finance railroads fueled from England and
the continent, and a speculative land boom in Germany and Austria fueled by the French
gold indemnity paid to Prussia after the Franco-Prussian war. The Austrian, German

10
boom collapsed in a spectacular stock market crash in Vienna in May. Stock markets in
Amsterdam and Zurich also crashed. In the U.S. a banking panic in September followed
the collapse of a stock market boom in New York with the failure of Jay Cook, a major
financier and President of the Union Pacific railroad. According to Kindleberger, the
German crisis contributed to the U.S. event as capital flow was cut off despite the fact
that the dollar was floating in this period which would have negated the price specie flow
channel of transmission. This crisis had serious repercussions in Latin America. The
downturn in the European economy ushered in by the crises and the turnaround in world
prices from inflation to deflation in this period reduced exports, tax revenues (trade taxes
were the principal form of taxation in Latin America), and debt service leading to a new
wave of defaults (Marichal 1989).

1890. The Baring crisis of 1890 triggered an international crisis in England and Latin
America that has resonance for today. The crisis culminated a major lending boom from
England and the continent in the 1880s to Argentina and Uruguay to finance railroads and
other infrastructure. Many of the loans went to the Argentine provincial banks, that were
not financially sound, fueling a monetary expansion and their collapse. The international
crisis erupted when the House of Baring (a major investment bank in London that held
the unsaleable paper of the Buenos Aires Water Supply and Drainage Company) declared
itself to the Bank of England to be insolvent on November 8, 1890. The Bank prevented
a panic by arranging a lifeboat operation to re-capitalize Barings with the aid of other
major London financial institutions and a temporary rescue loan from the Banque de
France and the Russian central bank. The crisis spread back to Latin America with the
cessation of British lending to Argentina, Uruguay, and Brazil. According to
Kindleberger the 1890 crisis was also linked to a major bank failure in Paris in 1889 and
was the foundation for a later series of crises in 1893.

1893. Major crises in the U.S. and Australia in 1893 have been linked to the earlier
Baring crisis and to a general downturn in the world price level. The U.S. panic of 1893
is generally associated with the Sherman Silver Purchase Act, a fillip to the Free Silver
Movement, which led investors fearing that the issue of silver certificates would force the

11
U.S. off the gold standard, to flee the U.S., hence precipitating a gold outflow and
monetary contraction. The proximate cause of the massive banking panic in the summer
of 1893 was a stock market collapse and increase in commercial failures that awakened
fears about the solvency of commercial banks.
The Australian crisis was preceded by a land boom, which was in large part financed by
domestic bank lending. The immediate cause of the panic was falling export prices,
which made it difficult for the pastoral sector to repay its loans. The trigger was the
closure of three banks. The crisis was aggravated by a withdrawal of British deposits and
loans. Retrenchment by the surviving banks in turn precipitated a long depression (Bordo
and Eichengreen 1999).

1907. The 1907 crisis had many of the attributes of the earlier crisis but in terms of its
international scope and its virulence it was probably the worst of the gold standard era.
According to the chronology in Bordo and Eichengreen, 9 out of their 21 countries were
hit by crises. The trigger is said to have been the Bank of England, which began raising
its discount rate in 1906 from 3.5 percent to 6 percent to counter a gold drain. This action
had the effect of reversing the flow of gold to the U.S. and severely tightening U.S.
money market conditions. A stock market crash occurred in early 1907, and economic
activity began to decline. In October, depositor runs on trust companies spread to the
commercial banks. The money stock declined precipitously, banks suspended cash
payments, and the economy entered a sharp recession. According to Kindleberger
(1986a) the crisis spread from England via France to Italy, which had been undergoing a
speculative boom. The connection was by Paris clearing its decks of London securities
and both centers stopped lending to Italy and other peripheral countries (Bonnelli 1982).

1914. The outbreak of World War I precipitated a massive international financial crisis
across the world. In the Bordo-Eichengreen (1999) sample of 21 countries, 15 countries
had currency crises, banking crises, or both. This crisis, unlike the others, did not spread
from the core to the periphery but occurred virtually simultaneously in all countries as the
belligerents scrambled to liquidate foreign assets. This led to panics in all asset markets

12
and a scramble for high-powered money. Banking panics in the U.S., U.K., and other
countries were allayed by timely lender-of-last-resort intervention.

1920-22. The post war deflation and recession, triggered by monetary authorities in the
U.S., U.K., and other countries in an attempt to roll back the wartime inflation and post
war commodity boom and to restore price levels to their prewar gold standard levels,
were associated with both banking and currency crises in a number of countries
(Denmark, Italy, Finland, Netherlands, and Norway). However, unlike the crises of the
nineteenth century there was no clear pattern of international transmission.

1929-33. The stock market crash on Wall Street in October of 1929 ushered in the
greatest worldwide contraction of all time. The collapse in world output from 1929-33
was heralded by a collapse in commodity prices in the emerging countries. The stock
market boom in New York by 1928 choked off U.S. capital flows to central Europe and
Latin America and precipitated currency crises in a number of countries (Australia,
Argentina, Uruguay, and Brazil) early in 1929 (Kindleberger 1986a). The Wall Street
crash precipitated by tightening Federal Reserve policy was instantly reflected in stock
market crises around the globe.

The story of the international propagation of the Great Depression is well known
(Eichengreen 1992, Kindleberger 1986b, Friedman and Schwartz 1963). The U.S.
downturn in 1929 turned into a depression in 1930 and 1931 after the Federal Reserve
failed to allay a series of banking panics. The resultant collapse in prices and output
worldwide forced sovereign borrowers to cut back on servicing their debts and then to
default, precipitating a collapse of foreign lending in 1931. At the same time the U.S.
induced depression and deflation precipitated banking and currency crises in central
Europe, forcing the U.K. to abandon gold in 1931. Transmission occurred through gold
flows, the money supplies, and capital flight. Adherence to gold for most countries acted
as “golden fetters” preventing monetary authorities from following expansionary
monetary policy (Eichengreen 1992).

13
3. Correlations Analysis

Recent studies, such as Baig and Goldfajn (1998, 1999), Forbes and Rigobon (1998),
have tested for contagion in financial markets by examining the behavior of the
correlation across countries, in financial market variables, such as securities prices,
interest rates and exchange rates. Whereas high correlations across countries is not in
itself evidence of contagion, as this may merely reflect historic cross-country
dependence, significant increases in the correlation coefficient are typically interpreted as
evidence of contagion. The idea underlying such tests is the view that the strength of
cross-country linkages is state dependent. The occurrence of a bad state, in particular a
crisis, excites otherwise dormant channels of transmission, radically changing the nature
of the linkages between countries, thus amplifying the cross-border impact of a shock,
which shows up as an increase in the correlation coefficient.

However, cross-country correlations are highly volatile, whether during turbulent periods
or periods of relative tranquility, which makes this type of analysis sensitive to the choice
of crisis windows. Moreover, as Forbes and Rigobon (1998, 1999) have shown, this
volatility is not necessarily a reflection of the changing patterns in cross-country linkages.
Rather this type of instability may be the outcome of the heteroscedastic nature of the
shocks impacting on the markets.10 Specifically, if x and y are two series such that yt =
βxt + ut, where ut is a disturbance, the correlation between x and y is given by
σx
ρ (x, y) = β , where σ x , is the variance of x and σ y , is the variance of y. Now to the
σy

10
Unfortunately the Forbes and Rigobon (1998, 1999) result is occasionally misinterpreted. Some have
interpreted the result as saying that the sample correlation coefficient is a biased estimator of the population
correlation coefficient, when heteroscedasticity is present. As elementary statistics has taught us, this is not
true. The sample correlation coefficient is indeed biased, in small samples, but the size of this bias depends
not on the stochastic properties of the parent populations, but rather on the sample size, and the true value
of the population correlation coefficient. See Fisher (1915), Gayen (1951) and Ruben (1966). The point
that Forbes and Rigobon are making is that if two series x and y are linearly related according to the
equation yt = βxt + ut, then an increase in the variance of x can lead to an increase in the correlation
between x and y, even though the value of β has remained unchanged. This point is made by means of a
very cute example involving a coin tossing game in two stages, in Forbes and Rigobon (1999). We have
made a stand here and directed the reader to Forbes and Rigobon (1999), as well as numerous seminal
contributions in the statistics literature governing the distribution of the sample correlation coefficient,
before this confusion spreads through the literature in aptly contagious fashion.

14
 σx
extent that the ratio of the variances , is changing the correlation between x and y will
σy
also be changing.

In this section, we examine the evidence of increases in correlations following a financial

crisis in three periods of our history. Given the frequency of our data, in order to allow
sufficient degrees of freedom, we examine the evidence of changes in correlations in six-
month windows of time.11 We present the results of our correlation analysis in two ways:
(1) in a set of tables that reports pre-crisis and post-crisis correlations, as well as the
increase in correlations in the post-crisis period, where increases in correlations that are
significant after adjusting for heteroscedasticity are shaded; (2) in a second set of tables
that report the average pre-crisis and post-crisis correlations between the crisis countries
and the emerging countries and between the crisis countries and the advanced countries.

3.1 The Pre World War I Period

In order to compare correlations in the pre-crisis period with those of the crisis period, it
was necessary to have some additional information regarding the timing of crises than
could be obtained from an annual chronology such as that reported in Bordo and
Eichengreen (1999). In each period of instability we discuss the chain of events that
culminated in a financial crisis. Other than providing an explanation of the proximate
causes of each crisis, this discussion provides clues as to the timing of the events. Since a
crisis, banking or currency, however defined, is never so precise as to present an obvious
demarcation of a period of tranquility from a period of crisis, the eventual choice of crisis
windows is somewhat subjective. Moreover, since crises often occur sequentially across
countries, the contagion stemming from a turbulent period typically cannot be attributed
to any single event. These caveats need to be kept in mind when interpreting an analysis
based on pre- and post-crisis correlations.

15
The Baring crisis in 1890 erupted on November 8, 1890, when the House of Baring
declared itself to be insolvent to the Bank of England. The crisis had its roots in the
lending boom from the UK to Latin America. Though a successful rescue package
arranged by the Bank of England limited the fallout from the crisis in London, the effects
of the crisis were felt in Latin America for several years. The acute financial crisis and
monetary instability in Argentina, which began in March of 1890 continued well into
1894 (Thorp 1926). A revival from this depression did not begin until 1895.

Attracting between 40 and 50 per cent of all British funds invested abroad, Argentina in
the 1880s was the single most important destination of British capital (Eichengreen
1997). Following the earlier episodes of default in the 19th century, Argentina’s return to
the international capital market reflects a combination of both monetary reforms and low
interest rates in London.

The inflows of foreign capital fueled a speculative bubble in real estate prices. The
bubble eventually burst at the end of the decade, with real estate prices falling in excess
of 50% (Batchelor 1986). As a result of its speculative activity, the Banco de la Nacion
(one of the two national banks of Argentina), found itself unable to make its dividend
payments, triggering a run on the whole banking system. By April of that year, the
Argentine government found itself unable to make its interest payments. Despite initial
attempts to reschedule loans and the negotiation of a 10 million pound loan from London,
government finances collapsed.

The crisis spread to London when Baring Brothers declared their insolvency to the Bank
of England. A rescue package arranged in secret helped minimize the fall out from the
crisis. The effects of the crisis were not solely restricted to Latin America, as countries as
far a field as Australia and New Zealand found it difficult to raise external finance.

11
Our data for the prewar period covers two non-adjacent years – 1890 and 1893. Since the crises we
consider often occurred in the last quarter the post-crisis windows are typically taken to be the last quarter
of each year.

16
The origins of the banking crisis in the US in 1893 can be traced to the enactment of the
Sherman Silver Purchase Act, which was passed on July 14, 1890. The act which
stipulated that the Treasury should step-up the purchase of silver to 4.5 million ounces
per month (Friedman and Schwartz, 1963), introduced fears that this purchase of silver
would produce an inflation that would force the US of gold. These fears were re-ignited
when a series of runs on trust companies in New York, including the Knickerbocker
Trust Company in October 1893, introduced doubts about the solvency of the banking
system. A banking panic ensued.

Table 1, which is divided into three parts, reports the unadjusted pre- and post-crisis
correlations along with the increases in correlations in the post-crisis period. An asterix
denotes that the increases are significant at 10%, while a double asterix indicates
significance at 5%.12 Shaded entries are significant after adjusting for heteroscedasticty.
Tables 1 a) and 1 b) examine the correlations in crisis and pre-crisis periods during the
Baring crisis. Specifically, Table 1 a) focuses on the contagion stemming from the crisis
in Argentina, which can be traced to the troubles of the Banco de la Nacion in March.
The period of tranquility is thus defined as the six-month window prior to this event. The
period of crisis is defined as the six-month window after the start of the crisis in
Argentina.

Table 1 b) focuses on the contagion following from the insolvency of Baring Brothers.
Even though Barings disclosed its financial difficulties in November, the crisis window is
defined to start in the first week of October. The reason for this has to do with data
constraints. Taking the crisis-period one-month back allows more degrees of freedom
with which to estimate post-crisis correlations.

12
The distribution of the sample correlation coefficient is complicated. However, a simple transformation,
known as the Fisher z transformation, brings the distribution close to normality (Fisher 1915). In order to
test the null hypothesis that two samples of size n1 and n2 are from two independent bivariate normal
populations with correlation coefficients ρ1 and ρ2 such that ρ1= ρ2, we employ the following test statistic:
(
U = z1 − z 2
) , where zi = tanh-1(ri), where ri is the sample correlation
[(1 n1 − 3) + (1 n2 − 3)]
coefficient.

17
Table 1 c) examines the impact of the October 1893 banking panic in the US. The crisis-
period is defined to start in the first week of October. The period of tranquility is taken to
be the six-month window prior to this.

Tables 2 a), 2 b) and 2c) report the average pre-crisis and post-crisis correlations between
the crisis affected country and the emerging countries as a group and the advanced
countries as a group.

Table 1 a) shows that in the pre-crisis period movements in Argentine bond prices were
correlated with movements in bond prices in the Netherlands. Negative correlations are
observed with Brazil and Chile. Interestingly, the correlation with the UK is highly
negative despite the fact that the UK was the largest supplier of capital to Argentina.

In the post-crisis period, we observe that, with the exception of Canadian bonds, price
movements of Argentine Cedula bonds were correlated with those of all other foreign
bonds. In particular, we observe a high correlation between the Argentine and Dutch
bond markets. High correlations are also seen to exist between Argentina and Chile, as
well as with the core European nations and the US. The two sharpest increases in
correlations are between Argentina and Chile and Argentina and the UK. However, only
the increase in correlations with UK are significant at 5%, and these increases remain
significant at 5% even after correcting for heteroscedasticty. There thus seems to be
evidence of contagion from Argentina to the UK.

The sharp increase in correlation between the UK and Argentina is consistent with the
spread of the crisis to London. Figure 2 plots the price of Argentine and UK bonds over
time. In the period prior to the crisis, the two series can be seen to be moving in opposite
directions. However, from April onwards, one month after the crisis in Argentina was
well under way, the movements in the two series are correlated with each other.

Table 2 a) reports the average correlations between Argentina and the emerging countries
in our sample, as well as the advanced countries. The Table suggests that in the pre-crisis

18
period, the correlation between Argentina and the emerging countries was significantly
higher than the correlation between Argentina and the advanced countries. In the post-
crisis period, correlations with both advanced and emerging countries rise strongly.
However, if we exclude the UK from the set of advanced countries, then correlations with
the two remaining advanced countries in our sample are seen to decrease in the crisis
period.

In Table 1 b) we switch our attention to the behavior of cross-market correlations in the

period following the announcement of the insolvency of Baring Brothers. Several
patterns are apparent. We see that in the pre-crisis period, the UK displays high
correlations with all the countries in our sample. In particular, we observe high
correlations between the UK and Canada and the UK and the US. These high
correlations may reflect the importance of trade linkages. In particular, the UK was the
second most important export market for Canada. We also observe a high correlation
between the UK and Chile. This may reflect Chile’s openness and strong reliance on its
exports of nitrates to the European nations. Interestingly, the correlation between France
and the UK is small.

In the post-crisis period, we observe that with the exception of the Netherlands and
Argentina, the correlations between the UK and the other nations in our sample turn
sharply negative. Interestingly, the correlation between the UK and the other Latin
American countries with the exception of Argentina are negative. The analysis seems to
suggest that there may have been contagion from the UK to Argentina in the immediate
aftermath of the Baring crisis, even though the increase in correlations between the two
nations is not significant. In part, this may have to do with the proximity of the crisis in
Argentina and the later crisis in London. Since correlations between the UK and
Argentina had already increased following the turbulent events their, we would expect to
observe fairly high correlations between the two countries in the pre-Baring crisis period.

There is no evidence of contagion from UK to any other country. In fact, all other
correlations decrease in the crisis period. Table 2 b) summarizes this finding. We see

19
that even though pre-crisis correlations between the UK and the advanced as well as the
emerging countries are on average positive, in the post-crisis period they are negative.

Table 1 c) shows that prior to the crisis, US bond price movements were highly correlated
with bond price movements in Belgium, Brazil, Chile, France, the Netherlands, and the
UK. On average, we see that correlations between the US and the advanced countries are
higher in the pre-crisis period, see Table 2 c). Interestingly the correlations between the
US and Canada are small, even though these countries have traditionally shared strong
trade linkages. In the crisis period the correlations between the US and several countries
increase, both advanced and emerging, see Table 2 c). In particular, we observe sharp
increases in correlations with the UK, France, Brazil and Chile. However, correlations
between the US and Canada still remain fairly weak. Though we observe increases in
correlations between the US and several countries, none of these increases are significant,
even before we adjust for heteroscedasticity. Thus, though there may have been greater
comovement between bond markets, we cannot verify this to be statistically significant.

In summary our evidence for the pre World War I period suggests that correlations
between countries often increased during periods of turbulence. There is convincing
evidence of contagion in the aftermath of the Argentine crisis to both the UK and Chile.
However, the evidence of contagion following the Baring crisis on London is not as
compelling. Furthermore, the increases in correlations that we observe in the period
following the US banking panic in 1893, are not sufficiently strong to withstand
statistical scrutiny.

3.2 The Interwar Period

As can be seen from Figure 1, the years between 1929-1933 were the most heavily
polluted with crises. We focus on the contagion stemming from the onset of three
financial crises; the stock market crash of October 1929, the devaluation of sterling on
September 21, 1931, and the devaluation of the dollar following the enactment of the
Thomas Amendment in May 1933.

20
The crash of October 1929, though arguably symptomatic of the decline in economic
activity that was already underway, is seen by many as the trigger behind the sequence of
events that led to the onset of the Great Depression and that helped to pull apart the
already fragile international monetary system. On October 21, margin calls led to heavy
selling on the NYSE with the volume of sales exceeding 6 million shares. By October
29, this number had reached 16.4 million, which by today’s standard would imply a
trading volume in excess of one billion shares. See Malkiel (1996). However, the crash
is viewed, there is no doubt that it served only to deepen the slump in the US.

Moreover, the drop in economic activity in the US sparked a precipitous decline in the
terms of trade in several primary exporting nations at the periphery, in particular those in
Latin America. The negative shock to the terms of trade and the decline in capital
imports from New York caused a large outflow of reserves, that led many Latin
American countries to either impose exchange controls, or suspend convertibility
altogether and issue a moratorium on external debt service (Diaz Alejandro). By the end
of 1929, Argentina and Uruguay had already limited gold convertibility (Eichengreen
1996). Between 1930 and 1934, several Latin American countries allowed their
exchange rates to slip below official parities. The sequential impact of the crash was not
restricted to Latin America or the periphery. Australia and New Zealand imposed
exchange controls, while Canada sealed off the gold outflow by imposing an embargo on
gold exports (Eichengreen 1996).

Despite the shockwave emanating from the wake of the 1929 stock market crash, there
were few crises in that year relative to 1931. 1931 was by and far the "year of crises."
Altogether 18 countries in our sample of 21 experienced crises. With a banking crisis
well underway in the US, in May 1931, Austria suffered a severe banking crisis following
the failure of the Kreditanstalt, Austria’s largest private bank (Friedman and Schwartz
1963). Within a month the crisis had spread to Germany. In an effort to stem the outflow
of gold, the Austrian and German governments were forced to suspend gold
convertibility. The instability soon spread to the continent and the UK.

21
From the onset of the restoration of convertibility at the pre-World War I parity in 1925,
the UK was plagued with balance of payments deficits. During the six years that the UK
was on the gold standard, these deficits progressively worsened. The global slowdown in
demand and increasingly protectionist policies caused a slump in export earnings.
Moreover default on debt by several Latin American countries had a deleterious effect on
the external balance. By 1931, the crisis-ridden countries of Austria and Germany were
forced to impose exchange controls and place a freeze on interest payments. These
events served to accelerate the outflow of gold reserves. Moreover, within a backdrop of
depressed economic activity and high unemployment, rises in the Bank rate were no
longer viewed as a credible policy (Eichengreen and Jeanne 1998). On September 21,
1931, Britain was forced to abandon gold convertibility.

The UK’s departure from gold set the stage for several countries to break off their ties to
gold. Countries with close ties to the UK through trade linkages, as well as those that
relied on the London financial markets, followed sterling off gold and pegged their
currencies to the pound, thus forming the sterling area (Eichengreen 1996). Other
countries that followed the UK off gold, but that did not join the sterling area, included
Japan, who competed with the UK in the textiles industry, and Canada, who depreciated
her currency to a lesser extent than sterling (Eichengreen 1996). In all some 25 countries
followed Britain off gold within a year of the sterling devaluation (Friedman and
Schwartz 1963).

The Thomas Amendment to the Agricultural Adjustment Act was enacted into law on
May 12, 1933. The Amendment empowered President Roosevelt to reduce the gold
content of the dollar by as much as one half of it’s original content. Though coming after
a period of sustained instability in the US, culminating in the massive banking panic of
1933, the devaluation of the dollar had ramifications on an international scale. The
devaluation triggered another round of devaluations at the periphery, in particular in
Latin America.

22
Despite the severity and the international nature of the financial crises from this period,
that there was contagion in financial market variables is not necessarily so. The
sequential dethroning of gold convertibility over the period, is to a large extent a
reflection of the underlying weaknesses of the interwar gold exchange standard, which
helped to both foster and perpetuate shocks across international borders. The channels of
transmission of these shocks, have been well documented by Eichengreen (1992). Below
we test the evidence of contagion in bond markets. Our data for the interwar is more
comprehensive than for the pre-World War I period, providing coverage over a larger
number of countries for a larger number of years. We proceed as above by estimating the
correlations of weekly changes in bond prices for both crisis and non-crisis periods.

Tables 3 a), b) and c) report the pre- and post-crisis correlations in the periods prior to
and after the onset of the three crises, along with the increases in correlations in the post-
crisis periods. In particular, Tables 3 a) and 3 c) report the correlations between the US
and the other countries in our sample, while Table 3 b) reports the correlations between
the UK and the other countries.

From Table 3, some patterns are apparent that suggest the importance of linkages through
international trade, which are consistent with the predictions of standard gravity equation
models, see Eichengreen and Irwin (1998). For instance in the period of tranquility prior
to the stock market crash of 1929, or the devaluation of the dollar in 1933, we observe
positive correlations between the US and Canada that are consistent with historically
strong ties between the two nations through international trade. Moreover, we see that
prior to the devaluation of sterling in 1931, UK bond prices are highly correlated with
several European countries, including the core countries, France and Germany. In
particular, we observe strong correlations between the UK and Denmark, reflecting
linkages between these two countries through international trade.

These patterns are less pronounced in the post-crisis periods. For instance, from Table 3
a), we see that correlations between US and Canadian bond prices decrease sharply
following the stock market crash. In the aftermath of the crisis, the US bond market lined

23
up with the European markets. Yet prior to the crash the majority of the European
countries displayed negative correlations with the US. In fact the countries that depicted
positive correlations in the period of tranquility prior to the stock market crash, typically
show negative correlations in the aftermath of the crash. We observe a similar pattern
after the devaluation of the dollar. For a large number of countries showing positive
correlations with the US in the period of “tranquility,” correlations decrease in the
aftermath of the crisis. However during the sterling crisis, we observe that correlations
between UK bond prices and the majority of the European nations remain positive in the
post-crisis period. Indeed the patterns that we observe in the post-crisis period are
sharper. We see the UK is strongly correlated with the core European countries – France
and Germany – as well as with Canada and the US, reflecting the importance of trade-
based channels of transmission.

From Table 3 a), we detect little evidence of contagion from the US bond market, in the
period following the stock market crash. Although correlations are seen to increase in the
post-crisis period, none of these increases are seen to be statistically significant. Some of
the increases in correlations may reflect the operation of channels of transmission on both
the capital and current accounts. The rise in correlations between the US and Brazil and
the US and Chile reflects the transmission of instability to Latin America, which was
harshly affected by both the deterioration in the terms of trade and the sharp decline in
capital imports from the core, forcing many Latin American countries to impose
exchange controls and or suspend debt servicing.

Interestingly correlations between Argentina and the US are seen to decline in the crisis
period. This may reflect the early suspension of convertibility in Argentina, which halted
the decline in money supply that started a year earlier. Indeed M2 in Argentina and
Uruguay, which had both imposed exchange controls, increased between 1929 and 1930
(Diaz Alejandro), while M2 in the US decreased sharply over the same period. By
contrast, between 1929 and 1930, M2 fell by 4.5% in Brazil (Diaz Alejandro), and by
15% in Chile (Bordo and Schwartz 1996). The suspension of convertibility or the

24
imposition of exchange controls, however, eventually halted the decline in money supply
in these economies as well.

Table 3 b) suggests sharper increases in correlations following the sterling crisis than that
was observed following the crash in 1929. From column 3 of Table 3 b), we observe that
6 of these increases are significant at 10%. However, after correcting for
heteroscedasticity, we find that none of these increases are significant. This suggests that
a large proportion of the increase in correlations that we observe can be attributed to
greater volatility in the UK bond market.

From Table 3 c) we observe some evidence of increases in correlations following the

devaluation of the dollar. For instance, the correlations between the US and Finland, as
well as the US and Greece rise sharply. Indeed these increases are significant at 1%.
Moreover, they continue to be significant after we correct for heteroscedasticity. We also
observe smaller increases in correlation between the US and Canada as well as the US
and Chile. These are, however, not significant. Even though we see that correlations
with the US do not increase for many countries, we do observe sharp increases that
suggest that there could have been contagion from the US to Finland and from the US to
Greece. Interestingly, we observe little evidence of contagion from the US to the Latin
American countries, even though the devaluation of the dollar sparked another series of
devaluations and crises in these countries.

An interesting finding that emerges from our analysis is that typically the correlations
with the four emerging countries in our sample are low during tranquil periods, but are
often seen to increase sharply in the aftermath of a crisis. For instance prior to the stock
market crash, with the exception of Chile, the correlation between the US and the
emerging countries in our sample are either weak or negative. In the aftermath of the
crash, correlations with Brazil, Chile and Greece increase. We observe a similar pattern
following the sterling and dollar devaluations.

25
Table 4 summarizes these findings. Typically we observe that the average pre-crisis
correlations with emerging countries are lower than the average pre-crisis correlations
with the advanced countries. Moreover, the average post-crisis correlations with the
emerging countries are greater than the average post-crisis correlations with the advanced
countries following the stock market crash and the dollar devaluation. In each episode
the average increase in correlations with the emerging countries exceeded the average
increase in correlations with the advanced countries. Though this evidence is not
forceful, it is suggestive. The emerging countries were possibly more exposed to shocks
from the center countries.

In summary, we see higher correlations during turbulent periods. However few of these
increases can be verified to be statistically significant. Typically when we observe
increases in correlations, as we do in the aftermath of sterling crisis, these increases wash
out after we correct for heteroscedasticity. There is some evidence that seems to suggest
that disturbances often spread from the core to the periphery, with the emerging countries
depicting sharper increases in correlations on average. We also observe some evidence
of patterns that reflect the importance of trade-based channels of transmission. These
patterns are, however, typically more difficult to discern in the aftermath of a crisis.

3.3 The Recent Period

Tables 5 a) and 5 b) report the correlations in the periods prior to and after the Mexican
and Thai crises, as well as the post-crisis increases in correlations. While Tables 6 a) and
6 b) report the average pre-crisis and post-crisis correlations with advanced and emerging
countries as a group, as well as the average increases in correlations.

From Table 5 a) we can discern patterns in the pre-crisis period, which, as was the case
for the interwar, suggest the importance of regional linkages, as well as trade-based
channels of transmission. For instance prior to the crisis, Mexico is strongly correlated
with Canada and displays positive, though slightly weaker correlations, with the US,

26
which suggests the importance of regional ties. Mexico is also positively correlated with
several of the East Asian countries in our sample, in particular, with Hong Kong. After
the crisis, we observe that several of these correlations increase. In particular,
correlations with Thailand and Portugal increase significantly. The correlation between
Mexico and Denmark also increases significantly, however, the two countries are still
weakly correlated in the post-crisis period. After correcting for heteroscedasticity, we see
that none of the increases in correlations are significant at 5%, though the increase in
correlations between Mexico and Denmark is significant at 10%.

Table 6 a) reveals that on average correlations with advanced countries decreased in the
aftermath of the peso’s devaluation, suggesting that they were largely insulated from the
crisis in Mexico. Correlations with the emerging countries, however, increased sharply,
suggesting that if there was contagion, the emerging countries were more likely affected.

Table 5 b) reveals clear evidence of regional patterns. We observe that prior to the baht
devaluation, Thai interest rates were positively correlated with all the other Asian
countries. The correlations with the other emerging countries were either weak or
negative. Correlations with the advanced countries were in general negative, see Table 6
b). In the aftermath of the crisis, the correlations with several countries rise. Moreover,
there is still strong evidence of regional ties. Correlations with Hong Kong, Indonesia,
Japan, Malaysia, and Singapore are positive in the post-crisis period. Of these, the
correlations between Thailand and Indonesia and Thailand and Malaysia increase in the
turbulent period following the devaluation. This increase may reflect the onset of the
crisis in those countries. However, these increases are very small.

Correlations with the other emerging countries are seen to increase dramatically, see
Tables 5 b) and 6 b). Although none of these increases are significant at 5%, the rise in
correlations with Brazil and Mexico are significant at 10%. After correcting for
heteroscedasticity, we find that the increase in correlations with Brazil remains
significant at 10%.

27
From Table 6 b) we see that in the post-crisis period, on average, correlations with the
advanced countries increase. However, even after this increase, these correlations remain
weak. An exception is the correlation between Thailand and the US, which remains
significant at 5% even after correcting for heteroscedasticity.

Looking at Table 6 b), we observe that, unlike the interwar, or during the Mexican crisis,
the average increase in correlations with the advanced countries following the Asian
crisis were substantially higher than the average increase in correlations with the
emerging countries. However, even after this increase, post-crisis correlations with the
advanced countries, on average, are still negative. Whereas post-crisis correlations with
the emerging countries, were on average quite high.

In summary, there is some evidence of contagion in the aftermath of the recent Mexican
crisis to Denmark, and in the aftermath of the Thai crisis to Brazil. Correlations between
the US and Thailand are also seen to increase significantly in the aftermath of the crisis.
However, this evidence of contagion is not strong. Though we observe several increases
in correlation, these increases may, to a large extent, be attributed to greater volatility in
financial markets.

4. Are Linkages Tighter in General During Turbulent Periods?

Cross-market correlations, whether during periods of turmoil, or periods of relative

tranquility, are highly volatile. An analysis based on a comparison of correlations, in two
windows of time, is therefore sensitive to how we demarcate a period of turmoil from a
period of relative stability. Moreover, since crises can spread rapidly across international
borders, it is easy to muddle the effects of contagion from various crises. Our choice of
crisis dates, whether arbitrary, or following from some meaningful scientific
methodology, can thus crucially impact on the eventual conclusions that we draw.
Moreover, though cross-country correlations can be suggestive, such a methodology
cannot account for the complex inter-relationships that exist between countries and
cannot disentangle the effects of a shock in one country on another. That we observe

28
strong correlations between two countries, or a significant rise in correlations during
crises periods, may be by virtue of a complex chain of transmission and feedback effects
of which we are largely ignorant. Hence a rise in correlations between two markets
suggests but does not necessarily imply transmission from one market to the other.
Given these concerns, in this section we move away from the issue of contagion
stemming from specific countries and from the analysis of bilateral correlations, and
instead we ask the broader question, In general do markets display greater comovement
with each other during periods of volatility? Put another way, are turbulent periods more
conducive to the propagation of shocks than periods of greater stability?13

We use principle components analysis to examine the evidence of stronger comovement

across markets during turbulent periods in all three regimes. Principle components
analysis, allows us to shed some light on this issue by, in effect, collapsing the
dimensionality of the data. Principle components analysis, is a statistical technique that
linearly transforms a set of correlated variables into a smaller subset of uncorrelated
variables, in a manner that aims to capture most of the variation in the data. For any
given p variables, it is possible to extract p principle components, assuming that none of
these variables are perfectly correlated with each other. These p principle components
are just an orthogonal linear combination of the original variables spanning the same
space.

The basic statistics that emerge from principle components analysis are the p variances
(latent roots) of the principle components, and the associated p variable weight-vectors
(latent vectors) that serve as the basis for the transformation of the original variables.
The ith latent root, tells us what fraction of the variation in the original data is explained
by the ith principle component, while the sum of the first i latent roots, tells us how much
of the variation is explained by the first i principle components.

13
Bordo and Murshid (1999) use VAR analysis to examine whether comovement was greater following
periods of financial instability during the interwar. They find evidence to suggest that cross-market
linkages were tighter during these periods.

29
In order to compare the comovement in tranquil periods with that in turbulent periods, in
Figures 3 a), 3 b) and 3 c) we graph, for all three regimes, the cumulative variation in the
data that is captured by the first i principle components, for i=1,..,p, for both pre-crisis
and post-crisis periods. If there is greater comovement during turbulent periods, then the
graph of the post-crisis variation should be above the graph of the pre-crisis variation.

From Figure 3 a) we can see that there is some evidence of an increase in the
comovement in bond prices across all markets following the Baring crisis, however, there
is little evidence of greater comovement following the earlier Argentine crisis. We also
see evidence of excess comovements across markets following the US banking panic in
1893.

There is also evidence of tighter cross-market linkages in turbulent periods during the
interwar. In particular, bond prices are seen to show considerably more comovement in
the aftermath of Britain’s departure from gold in 1931. By contrast the evidence that
bond prices were more strongly correlated following the devaluation of the dollar, is
considerably weaker. Moreover, there is no indication of stronger comovement in bond
prices in the aftermath of the 1929 stock market crash.

For the recent period, the evidence of greater comovement during crisis periods is much
weaker. There is little suggestion that the overall extent of comovement was greater
following the Mexican crisis. Moreover, we observe that there was lower comovement
across countries in the aftermath of the devaluation of the baht.

The above analysis provides mixed evidence with regard to the overall extent of
comovement following a crisis. In particular, though we observe evidence that bond
prices were more correlated in the aftermath of a crisis in the pre World War I period and
the interwar, this is not the case for the recent period. This is not an altogether surprising
finding. During the earlier regimes, countries were tightly linked to each other through
the fixed exchange rates of their gold parities, which facilitated the transmission of

30
shocks between countries. This needs to be contrasted to the current managed floating
regime based on fiat money, which is arguably less open to macro shocks.14

If some countries are relatively insulated from the fallout emanating from a crisis, then
we would not necessarily expect to observe stronger cross-market ties across all
countries. However, it may be reasonable to expect to observe greater comovement
within various groups or clusters of countries in the post-crisis period.

The analysis in section 3 revealed patterns in cross-country correlations that could serve
to provide a means by which to separate countries into various groups, in particular
regional ties were often seen to be important. Thus we divide the countries into regional
groups and examine the extent of within-group comovement in the pre-crisis and post-
crisis periods. Moreover, one of the stylized facts of the analysis in section 3 above has
been that average correlations with advanced countries decrease in the post-crisis period,
or at least increase to a lesser extent than correlations with emerging countries. This
seems to imply that advanced countries may be more insulated from the impacts of
international shocks than emerging countries and thus suggests that a division along the
lines of emerging and advanced countries may be revealing.

In Figures 4 a) and 4 b) we graph, for the various crises during the interwar and the recent
15
period, the intra-regional variation in the data that is explained by successively
increasing numbers of principle components. Similarly, in Figures 5 a) and 5 b) we
graph the variation within the group of advanced and emerging countries.

From both Figure 4 and Figure 5, we see that the evidence of stronger comovement
within various groups of countries following the onset of a crisis is mixed. There is some
evidence of stronger cross-market linkages following the sterling and dollar devaluations
during the interwar. This evidence is weaker for recent period. There is, however, some

14
This of course needs to be qualified by the effects of increasing open capital markets, which offset the
insulation properties of floating exchange rates. Also it should be noted that within the rubric of the
managed float regime, many of the countries in our sample at various times have pegged their currency to
the dollar or other dominant currencies.

31
indication of an increase in comovement following the devaluation of the peso within the
set of advanced countries as well as within the set of emerging countries.

From Figure 4 a) we observe evidence of a strong increase in the comovement in bond

prices between the European countries following the onset of the sterling devaluation.
Moreover, Figure 5 a) suggests that the extent of comovement between the set of
advanced countries, which includes several European countries in our sample increased
sharply in the aftermath of the sterling crisis. There is somewhat weaker evidence of
stronger comovment between the Latin and North American countries following the
stock market crash of 1929. And there is little suggestion of an increase in intra-regional
comovement following the devaluation of the dollar.

For the recent period there is some evidence of stronger linkages following the onset of
the Mexican crisis. In particular, we observe evidence of an increase in comovement
between the set of advanced countries as well as the set of emerging countries. The
evidence of greater comovement within the Latin and North American region is weak.
However, this evidence must be interpreted liberally, since this group consists of only
three countries, namely the US, Canada and Mexico.

Interestingly there is little indication that cross-country ties were greater within any
region other than Europe, following the devaluation of the baht. For all other regions,
including the Pacific rim, we observe a decrease in the overall extent of comovement.
This is interesting, since many of Pacific rim nations were affected by the fall out from
the Thai devaluation.

In summary, we find some evidence during the earlier regimes of tighter cross-market
linkages across all markets during periods of turmoil, but little evidence of this for the
recent crises. There is some evidence of greater market comovements within groups of
countries during periods of financial instability in the interwar. This evidence is much

15
Since our data for prewar era covers only nine countries, we omit the analysis of this period.

32
weaker for the recent period, though there is a suggestion that cross-market linkages may
have strengthened in the period following the peso’s devaluation.

5 Conclusion

In this essay, we have examined seven particularly severe instances of financial

instability, spanning 108 years and three regimes, each significantly distinct from the
other. Yet from each episode, several underlying themes have emerged. We find that
periods of turbulence are typically characterized by higher cross-market correlations.
The volatile nature of financial markets means that correlations between markets are
always changing, however, this inherent instability in the correlation coefficient is not
necessarily a reflection of continuously changing cross-market linkages. Rather these
complex dynamics may be a consequence of the heteroscedastic nature of disturbances
impacting upon these markets. After adjusting for heteroscedasticity, we find that very
few of the increases in correlations can be verified to be statistically significant,
suggesting that the dynamics of the correlation coefficient reflect greater volatility rather
than instability in cross-market relationships. Nevertheless there is some evidence of
isolated cases of contagion between specific countries, during all three regimes that we
have examined.

The volatility in the correlation coefficient blurs the underlying relationships between
markets. Even so, in each episode we have been able to discern regional patterns in
correlations that may suggest the importance of trade-based channels of transmission.
Although during periods of financial instability these patterns are occasionally more
difficult to discern.

Principle components analysis has revealed that the extent of comovement across markets
is often unchanged in the aftermath of a crisis. Given stronger correlations between some
countries, this evidence suggests higher variance in cross-market correlations during
periods of instability. Dividing countries into various regional groups, or along the lines
of advanced and emerging, has, however, suggested some tendency of stronger

33
comovement within various groups of countries, particularly during the interwar. By
contrast, the evidence of stronger intra-regional or intra-group variation during periods of
instability for the recent period, is far weaker.

In summary, despite some evidence that correlations increase during turbulent periods,
and of stronger intra-regional comovement during the interwar, we have not been able to
establish a strong case for contagion, especially for the recent period. The increases in
correlations that withstand statistical scrutiny are often difficult to justify on the basis of
traditional channels of transmission. This very small number of significant increases
could support the idea of contagion, or they could merely be spurious. From a
perspective of weeks rather than days, the evidence on contagion is sporadic, and can
only be convincingly identified in a discrete number cases. Yet these are the exceptions
to the rule that have commanded our attention. Our evidence suggests that the emphasis
on contagion in the recent literature is clearly overblown and hence the case for an
international crisis manager or an international lender of last resort to deal with contagion
is not transparent.

34
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