Financial Frictions, Financial Integration and the International Propagation of Shocks

41 Pages Posted: 9 Apr 2012

See all articles by Luca Dedola

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Giovanni Lombardo

European Central Bank (ECB)

Date Written: April 2012

Abstract

The recent Great Recession has been particularly remarkable not only for its unprecedented severity, but also for the exceptional degree of global interdependence in financial and real variables. A much‐discussed channel of propagation hinges on the international exposure of the balance sheet of highly leveraged players to ‘toxic’ US assets. Yet, existing evidence on the role of exposure is mixed at best. This paper argues that under financial integration, the fact that leveraged investors face the same returns across internationally traded assets, would tend to equalize their borrowing cost across countries. Model simulations show that an unexpected increase in credit spreads in one country generates a similar increase in credit spreads in other financially integrated countries bringing about a global contraction, quite independently of the exposure to foreign assets in the balance sheet of leveraged investors. Our analysis thus suggests some caution in assessing the risks of ‘contagion’ on the exclusive basis of quantitative measures of integration based on cross‐border balance sheet exposure. — Luca Dedola and Giovanni Lombardo

Suggested Citation

Dedola, Luca and Lombardo, Giovanni, Financial Frictions, Financial Integration and the International Propagation of Shocks (April 2012). Economic Policy, Vol. 27, Issue 70, pp. 319-359, 2012, Available at SSRN: https://ssrn.com/abstract=2035304 or http://dx.doi.org/10.1111/j.1468-0327.2012.00286.x

Luca Dedola (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Giovanni Lombardo

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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