Assistant Professor Isabel Trevino on Financial Contagion

Financial contagion is the spread of market disturbances. How do people process information related to different channels of financial contagion? UCSD Behavioral Economist Professor Isabel Trevino has added to our understanding of the channels of financial contagion both theoretically and with experimental evidence in her paper published in the January 2020 issue of Econometrica.

Isabel discusses how two main classes of channels are studied as informational sources of financial contagion. One is a fundamental channel that is based on real and financial links between economies, and the second is a social learning channel that arises when agents base their decisions on noisy observations about the actions of agents in foreign markets. Using global games, this paper presents a two country model of financial contagion in which both channels can be operative and its predictions are tested experimentally in an effort to distinguish the relative strength of these channels as determinants of subjects’ behavior. While the theory makes clear statements about which channel should be relevant in the different treatments of the experiment, we observe systematic deviations in the way subjects use the information at their disposal. Two main biases arise: a base rate neglect bias, by which subjects underweight their prior, and thus rely less on the fundamental channel, and an overreaction bias where subjects put too much weight on the information derived by the behavior of agents in a foreign market, thus strengthening the social learning channel. These results have important welfare consequences and provide a characterization of the conditions in the economy that can increase or reduce the strength of each of these channels in spreading contagion.