We study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries' liquidity markets. We show that segmentation allows a country to avoid contagion and fend off mild financial crises caused by a small shock to its liquidity demand, at the cost of exposing it to more severe financial crises caused by a large shock. We derive a "pecking order" result, whereby segmentation is a second-best measure that coordinated governments should use only when tax capacity constrains them from injecting liquidity. Even when segmentation is welfare-enhancing, it should be applied to public liquidity alone, never restricting the free ow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.
Contagion; fire sales; financial crisis; financial stability; segmentation; liquidity injection;
Alexander Guembel, and Oren Sussman, “The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises”, TSE Working Paper, n. 14-498, March 2014, revised March 2019.
The Review of Economic Studies, 2020, forthcoming