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Krishnamurthy (2001) contractual distortions in the treatment of domestic and international collateral can induce fire sales (presumably that are worse than those that would have arisen if cross-border lending was limited), resulting in liquidation of assets at a significant discount in the event of a shock. In a related vein, in Mendoza (2010) information costs, high leverage and borrowing constraints combine to cause fire sales. Traders facing high debt levels and borrowing constraints can be forced into fire sales of assets to less informed foreign buyers, even though the shock is only temporary. Such fire sales can precipitate rapid shutdowns of external capital markets (i.e. countries facing these fire sales lose access to foreign funds) and large consumption contractions. 19 Stiglitz (2002) described how these effects served to deepen the East Asia crisis of 1997–1998.
    The spread of crises to economies that have the same creditors or investors (such as global banks or hedge funds) as the economy in crisis constitutes another channel for the transmission of shocks. Creditors or investors that suffered losses in a crisis in one economy are likely to modify their lending or investment strategy with respect to seemingly unrelated economies. When banks face loan defaults, they are likely to scale back lending to all borrowers, even those unaffected by the initial adverse event, due to capital requirements or balance sheet effects. The worse the effect of defaults on the bank’s financial health and ability to raise equity, the more pronounced the cutbacks in lending to other borrowers. Because of information asymmetries, lending cuts may be disproportionately large for foreign borrowers. Chava and Purnanandam (2011) find empirical support for the role of lender portfolios in the transmission of shocks to previously unaffected firms in a study of borrowers dependent on bank debt around the 1998 Russian financial crisis. Rashid (2011) similarly finds that foreign banks play an important role in the transmission of shocks across borders.
    Similarly, investors who lose money in one market might liquidate their positions in other economies (to cover losses or meet margin requirements). Shocks, therefore, can be transmitted as a result of portfolio rebalancing by investors with stakes in multiple markets (Kodres and Pritsker, 2002). Investors are expected to respond to shocks that affect a given market by modifying portfolio exposures to shared macroeconomic risk factors. Such cross-market linkages are likely to spread shocks faster during bad times and in the presence of high levels of foreign debt, as was the case for emerging economies in the Asian financial crisis. But even if there are no shared macroeconomic risks, globally diversified investor portfolios can also speed propagation of individual country shocks to other economies through investor wealth effects (Kyle and Xiong, 2001; Goldstein and Pauzner, 2004). A crisis in one country leads to a reduction in the wealth of those invested in that country. The decline in wealth causes investors to rebalance portfolios, and possibly even to act in a more risk-averse manner, so they scale back holdings of risky assets in other countries, even when those other countries share no ties or risk factors with the original economy in crisis.
    Finally, crises can be transmitted via the real sector, for example, through trade ties and competitive (terms-of-trade) effects. Shocks affecting developed countries eventually affect developed countries’ trade partners. The recent US economic downturn resulted in a slowdown in gross domestic product growth and a reduction in import demand, adversely affecting many developing economies that traditionally exported to the US (Stiglitz, 2010b). Adverse exchange rate effects would, in the standard model, be viewed as purely redistributive – one country gains what the other country loses – but with financial constraints, as we