Financial contagion is a process by which economic problems are transmitted from one domain to another via financial linkages between the two domains. These effects can bring about widespread loss of employment, falls in asset values, and societal demoralization, and can easily lead to riots and even revolution. Contagion can occur from one firm to another or across two industries, for example. But because the larger the domain, the greater the economic and societal effects, the most important focus is on contagion nations. As finance is a branch of economics, so financial contagion is a subspecies of economic contagion. There are several factors that make financial contagion especially troublesome and particularly worthy of attention.

Let us first consider two rudimentary economies without any financial sector. These ...