Does International Financial Contagion Really Exist?

In the 1990s, exchange rate crises followed stock market crashes and sharp economic contractions, with devastating effects on countries around the world. The frequency and extent of these events led many policymakers, regulators, journalists, and market participants to declare a “crisis of global capitalism” and to call for a new “international financial architecture.” When financial crises occur in neighboring countries in rapid succession, it is tempting to believe that financial distress is capable of spreading like a contagious disease. Moreover, it is logical to look for potential carriers of such a disease among market participants such as commercial banks, international mutual funds, and global investors. The problem, however, is that much of the evidence does not support the idea of international financial contagion. This article surveys and synthesizes the empirical evidence on international asset price co‐movements, the volatility of cross‐border capital flows, and the relationship between those flows and asset prices. A careful reading of this evidence suggests that the observed co‐movements during the 1990s might not have been excessively large, given the global economic and capital market environment. As the author suggests, the appearance of what some might call contagion could instead be attributed to errors in domestic financial policies that have simply been repeated many times by affected countries in response to common economic shocks. And this in turn implies that while the various reform proposals to date have been directed mainly at the international and supra‐national level—involving questions such as the appropriate exchange rate and international financial market regimes, and how to organize the IMF and the World Bank group of the future–the most important questions may be those concerning government policy at the national level. Fiscal and monetary policymakers may need to rethink how their governments regulate access to the domestic financial sector, how their markets are supervised by the central bank, and how such supervision can be used to improve risk management for the financial service sector.