The Cause, Effects, and Implications of Financial Contagion

In addition, financial contagion bears witness to market inefficiencies. As examined herein, financial markets appear to exhibit information arbitrage efficiency.14 At no point does it appear possible for any investor to earn consistently above average abnormal returns using information on financial contagion. It does not appear possible to use one country's asset prices to predict the asset prices in other markets; thus it is not possible to consistently gain profits. While information arbitrage efficiency is present, it does not appear that this is the case with fundamental value efficiency. With financial contagion, asset prices do not reflect all available information on asset values due to the fact that asset prices fluctuate more than they should if fluctuations were based solely on fundamental values. If fundamental value efficiency were present in the world's markets, there would be no financial contagion and shocks in one market would not be transmitted to other markets, as asset prices in every market would reflect fundamental values.

Implications for the Future

What are the implications for the future to be drawn from this examination of financial contagion? A better understanding of financial contagion and an explanation of recent financial crises is a good development in its own right, but what good is our understanding if we do not use it as a tool, a tool we can use to attempt to reduce financial contagion in the future?

Reducing instability in developing countries would greatly aid in increasing their development. One way in which instability in developing countries can be reduced is by reducing the instability of their financial markets. A great cause of instability in emerging markets is financial contagion, as witnessed by the recent financial crises in emerging markets. Reducing financial contagion would increase the stability of emerging markets, and thus lend itself to fostering stability in developing countries.

One way in which financial contagion can be reduced is by reducing information asymmetries. As we have seen, the higher the degree of asymmetric information in a market, the greater the effect of financial contagion in that market. If steps could be taken to increase the availability of information to all investors, information asymmetries could be reduced, simultaneously reducing the probability and severity of the transmission of shocks between markets.

In addition to reducing information asymmetries in emerging markets, financial contagion could be reduced if something was done to close the channels of contagion. As has been seen, financial contagion often flows between emerging markets through developed markets. If cross-market rebalancing could be limited to occurring in developed markets, which can better handle contagion, shocks would not be transmitted to emerging markets, markets that are less able to handle trauma. If information could be passed to emerging markets regarding occurrences of cross-market rebalancing and other forms of contagion, the effects of the contagion in emerging markets would be lessened.

Most of these potential reforms to the financial system would serve to push the market closer to fundamental value efficiency. If prices better reflected fundamental values-that is, if markets exhibited fundamental value efficiency-financial contagion would cease to be the ominous threat to emerging markets that it currently is. Finding methods of reducing financial contagion and the instability it causes is of the utmost importance in facilitating the development of emerging markets and the growth of developing nations. The closer to exhibiting fundamental value efficiency markets become, the less markets will contribute to instability, allowing markets to serve their intended purpose: providing people with an efficient way to allocate resources over time and space.

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