A2 Systemic illiquidity and contagion

Topic

Systemic illiquidity and contagion encompass a phenomenon distinct from—though overlapping with—the "bubble and crash" dynamic: while the latter is measured by asset prices relative to fundamentals, systemic illiquidity is measured by the aggregate leverage of the entire financial system. The trigger for this anomaly is aggregate leverage surpassing the fragility threshold—the point at which the financial structure can no longer absorb a price drop without a lack of liquidity spreading from one entity to another.

Property and investment agents—firms, investors, and households—are modeled as nodes in a network rather than isolated atoms; this network representation explains why systemic illiquidity does not remain confined to its point of origin. When aggregate leverage crosses the fragility threshold, forced asset sales by an over-leveraged node drive down prices for the rest of the network, compelling other leveraged nodes to sell in turn; contagion thus spreads through the very connections that, under normal conditions, allow capital to circulate fluidly.

While distinct, this anomaly and the bubble-and-crash cycle often appear linked: sustained growth in aggregate leverage frequently finances the extreme price deviations characteristic of a bubble, meaning that when such a deviation abruptly reverses, it catches a financial system already teetering on the edge of its fragility threshold. The State—acting as a cross-cutting modifier that does not compete in any specific lane but participates directly in Property and Investment via the central bank—is the entity that typically intervenes to halt contagion once systemic illiquidity materializes; however, this intervention does not eliminate the aggregate leverage that caused the issue, but merely arrests its propagation through the network.

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