Contagion theorists argue that the global financial system is inherently fragile, meaning that if several significant institutions fail, the system will implode. But the evidence points to the opposite conclusion. The financial system is robust and able to deal with the failures of some of its largest institutions.
The justification put forth by regulators and politicians is that bailout money needs to be spent in order to ward off systemic collapse. In announcing additional aid to AIG on Monday, the Federal Reserve and the Treasury issued a joint statement pointing to the “systemic risk AIG continues to pose.” Given the large and growing price of keeping systemic risk at bay, it is important to explain exactly what it is.
The concept is straightforward. A large bank fails, and its counterparties, to whom it owes money, also fail and so on in a domino effect. Those who support this theory invariably point to vast sums of derivative contracts outstanding. If there are tens of trillions of dollars of derivatives contracts, it must be the case that the system is vulnerable to the failure of a large player...
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