The Uncertainty Channel of Contagion

Abstract

This paper analyzes the impact of uncertainty on the spread of stock market crises, both theoretically and empirically. The effect of uncertainty about the fundamentals on investment decisions is an important cause of financial crises propagating across countries. Firstly, a coordination game on investment illustrates the increasing effect of a surprise crisis in one country on the probability of a crisis in a second country through higher uncertainty there. An anticipated initial crisis generates the opposite effect. Secondly, these theoretical predictions are tested empirically. Fixed effects panel estimations validate the impact of the initial crisis on uncertainty in potentially-affected countries. Subsequently, probit estimations confirm the positive impact of uncertainty on the crisis probability in the affected economy. The results are robust across various specifications.