Conclusions from the Model
The most important conclusion that can be drawn from what we have learned about financial contagion is that countries do not need to be linked directly by macroeconomic fundamentals in order to transmit shocks. All that is required for transmission of shocks is for macroeconomic variables to be shared indirectly through other countries. This explains how contagion has occurred between weakly linked markets such as those of Latin America and Asia.The other most important conclusion about financial contagion to be drawn from our model is that information asymmetries exacerbate contagion. The effects of contagion on asset prices are much greater in markets with greater information asymmetries. Countries with high levels of asymmetric information experience great fluctuations in asset prices, whereas countries with low levels of asymmetric information do not. When high levels of asymmetric information are present, uninformed investors perceive changes in asset prices in other countries as possibly reelecting information held by informed investors, thus inducing them to alter their expectations about the fundamental value of assets, causing asset prices to change.12
Emerging markets have higher levels of asymmetric information than do developed markets. This explains why emerging markets are affected much more severely by contagion than developed markets. In emerging markets, information about fundamentals is less readily available, thus producing situations of high asymmetric information, exacerbating financial contagion. Financial contagion is often transmitted between emerging markets through developed markets. Because developed markets have less information asymmetry, they remain relatively unaffected by contagion, acting merely as conduits for the transmission of shocks between emerging markets. Ironically, reductions in asymmetric information in developed markets serve to worsen the effects of contagion in emerging markets where information asymmetries still persist.13
Implications of the Conclusions Drawn from the Model
Often when we consider financial markets, we consider the role they play in the efficient allocation of resources across time and space. We often neglect to consider the fact that sometimes, financial markets, while striving to facilitate efficiency, can have unintended side effects that cause instability. Through the transmission of shocks from one financial market to another through the channels of financial contagion, financial markets produce instability in emerging markets. Instability in emerging markets hinders development because emerging markets are prone to contagion-induced instability. Asset price fluctuations have worse consequences in emerging markets than in developed markets because emerging markets are relatively unstable. Often countries that are unstable financially are also unstable politically. Due to this instability, financial contagion can have wide spread harmful consequences in developing countries.Countries with developed markets for the most part view financial contagion as an emerging market problem unrelated to developed markets. This mindset is a result of the minimal effect financial contagion has on developed markets and the great effects it can have on emerging markets. The fact that developed markets serve to transmit shocks between emerging markets is often overlooked. We study the financial crises in Argentina, Brazil, Mexico, and Asia, and do not consider the fact that we play a role in these crises by providing channels of contagion.
The lack of information asymmetries in developed markets, while normally considered beneficial, also works as a negative externality in emerging markets. As discussed previously, the asymmetries of the information asymmetries in markets worsen financial contagion. Developed markets play a role in harming emerging markets while only minimal negative effects are felt in the developed markets-a negative externality. Since developed markets go unscathed while emerging markets are deeply affected, a type of market failure is present.
Be Sure to Continue to Page 4 of "The Cause, Effects, and Implications of Financial Contagion".
