Central bankers warned can limit, not escape contagion

JACKSON HOLE, Wyoming (Reuters) - Nations fearing financial contagion from troubled neighbors can reduce the risk by strengthening their banks, top monetary policymakers were told on Friday, which some saw as an argument for tough action now to stem more harmful damage later.

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

The first paper presented 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 defense was to bolster banks.

"Most of the channels of contagion result from a healthy interdependence between countries in good times, as well as bad," she wrote in the paper. "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 that 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.

Martin Feldstein, a professor at Harvard who is considered a possible candidate to head the Federal Reserve if Republican Mitt Romney wins the White House on November 6, said the paper highlighted his belief that the creation of the euro zone had deepened cross-border contagion risks.

He said this should spur policymakers to take the bold step of encouraging the euro to depreciate sharply against the dollar, in order to boost growth through exports in the smaller "peripheral" nations at the heart of the crisis.

Greece, Ireland and Portugal have all needed bailouts from the rest of the bloc's members. Because they all share the euro, they do not have a national currency they could devalue.

"I continue to believe (what) would be helpful ... would be a significant decline in the value of the euro, perhaps from $1.25 today back to parity with the dollar," Feldstein said during a question-and-answer session after the paper was presented.

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 are two other channels through which contagion spreads, 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 that they should ensure national investment portfolios were balanced, and that public policy does not favor 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 off certain types of cancer, there are policies that can effectively fend off certain forms of contagion," Forbes wrote.

Furthermore, it was important that policymakers made clear to the public and financial markets what their policy response would be in the event that a country - or an institution like a big bank - got into trouble, she said.

Franklin Allen, a professor at the University of Pennsylvania, said this finding suggested that it would make sense for Europe's leaders to let Greece exit the euro, rather than just keep propping it up, in order to educate markets about what to expect if much larger Spain, or even Italy, eventually face a similarly bleak prospect.

"If Greece does leave it will provide some guidance," he said. "If we are going blind going into Spain and Italy, that could cause massive contagion."

"If the uncertainties are decreased then hopefully the contagion effects will be less."

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