Financial Contagion Party

Last night I went to a party. After a few hours pigging out and drinking wine and limoncello, someone started a discussion about the recent stock market downfall, asking why Chinese selloff triggered selloffs elsewhere in the world (e.g. US and Europe). Well, if all those pension funds, mutual funds, hedge funds and other savvy investors got out of Chinese stocks, shouldn't it increase demand for financial assets elsewhere? So why did US and European equity market went down also, instead of going up? well I had hard time answering the question myself. I remembered vaguely from my very limited reading that even economists had come up with hundreds of explanations, but no consensus yet. The best answer I could offer was the usual herding behaviour theory and the empirical fact popular after the 97 Asian crisis that markets are quite highly correlated, and therefore prone to financial contagion.

OK i got home and geeked out. So I searched "financial contagion" at Wikipedia and I found that Wikipedia article on financial contagion is well, still disorganized and a little too esoteric for most people. But I think this is the main point: "Despite of substantial progress in research, there is still no consensus on definition of contagion. Generally it may be defined as an excessive unanticipated increase in cross-market linkages after a shock to an individual country (or group of countries). ... Researchers argue that interdependence can be measured and anticipated. However, an existence of extreme, asymmetric patterns of excess volatility that can not be explained by fundamental links between economies has led experts to suggest that contagion - rational or irrational - can be the only remaining explanation." Which means that "Financial contagion" is the interdependence between financial market that experts cannot explain.

Then I found this nice page on financial contagion in World Bank's website. I am pleasantly surprised that this one was a little easier to read, but still concluded "So, What Is the Ultimate Cause of Contagion? This is a very hard question to answer. As you can find in this web site, different papers point toward different directions. "

OK if an army of smart people with average IQ of 180 or higher can't explain this, how can I explain? Here's my answer... Thanks to EclectEcon.