Confidence spillovers, financial contagion, and stagnation

Financial crises tend to spread across countries, causing equity price crashes that cannot be fully explained by fundamentals. This paper introduces a two-country dynamic general equilibrium model of global financial crises that distinguishes between interdependence and financial contagion. Interdependence arises through trade and capital flows, while contagion occurs through a new channel: confidence spillovers. In the model, contagion is possible due to multiple dynamic and steady-state equilibria, even with fully rational consumers. Self-fulfilling beliefs about equity prices can shift the economy between equilibria, amplifying negative effects and causing contagion. The model has three policy implications. Firstly, monetary policy can offset recessions without causing inflation. Coordinated international policy can potentially improve welfare further. Secondly, capital controls can prevent contagion. Lastly, increased trust in government can mitigate negative confidence shocks. These recommendations emphasize the role of beliefs, where pessimism can spread internationally via the confidence channel, leading to contagion. • The paper models global financial crises, distinguishing between interdependence and financial contagion. • Contagion occurs as a market “overreaction” via confidence spillovers, enabled by multiple equilibria in the model. • Shocks to beliefs about equity prices shift the economy across equilibria, amplifying negative effects and causing contagion. • Monetary policy can prevent contagion; extreme capital controls stop both contagion and interdependence. • Better government trust helps prevent negative confidence shocks, reducing the chance of contagion.