Contagious Adverse Selection
by Stephen Morris of the Princeton University, and
Abstract: We illustrate the corrosive effect of even small amounts of adverse selection in an asset market and show how it can lead to the total breakdown of trade. The problem is the failure of "market confidence", defined as approximate common knowledge of an upper bound on expected losses. Small probability events can unravel market confidence. We discuss the role of contagious adverse selection and the problem of "toxic assets" in the recent financial crisis.
Forthcoming in: American Economic Journal.