Financial Contagion and the Wealth Effect: An Experimental Study

Financial Contagion and the Wealth Effect: An Experimental Study

Oana Peia

How do crises spread across countries or markets?  Recent history has seen many
episodes of financial contagion such as the 2008 Global Financial Crisis, which
originated in the US and spread rapidly across the world, or the 2012 Sovereign debt
crisis, which led to spillovers in government bond yields across Europe.  Yet,
understanding the main channels through which contagion occurs is difficult, as
many confounding factors are at play during such episodes, including panics and
herding behavior. In a recent paper ((opens in a new window)Bayona & Peia, 2020), we employ a controlled
laboratory experiment that provides an ideal environment to isolate the relative
importance of the different channels of financial contagion. Our aim is to isolate the
importance of investors' wealth in explaining how financial crises spread across
markets with unrelated fundamentals.  We show that when investors have
completely diversified portfolios across countries, a crisis, which decreases their
wealth in one country, makes them more likely to liquidate investments in a second
market, thereby propagating crises across countries. When portfolio diversification is
small, we find that social imitation can explain contagion across markets with
unrelated fundamentals.