We study a two-country setting in which leveraged investors generate fire-sale externalities, leading to financial crises and contagion. Governments can affect the incidence of financial crisis and the degree of contagion by injecting public liquidity and, additionally, by segmenting the countries’ liquidity markets. We show that segmentation allows a country to avoid contagion and fend off mild financial crises caused by a small shock to its liquidity demand, at the cost of exposing it to more severe financial crises caused by a large shock. We derive a “pecking order” result, whereby segmentation is a second-best measure that coordinated governments should use only when tax capacity constrains them from injecting liquidity. Even when segmentation is welfare-enhancing, it should be applied to public liquidity alone, never restricting the free flow of private liquidity across countries. Uncoordinated governments tend to use segmentation excessively.

We develop a theory of sovereign borrowing where default penalties are not implementable. We show that when debt is held by both domestic and foreign agents, the median voter might have an interest in serving it. Our theory has important practical implications regarding (a) the role of financial intermediaries in sovereign lending, (b) the effect of capital flows on price volatility including the possible overvaluation of debt to the point that the median voter is priced out of the market, and (c) debt restructuring where creditors are highly dispersed.

It is commonly believed that prices in secondary financial markets play an important allocational role because they contain information that facilitates the efficient allocation of resources. This paper identifies a limitation inherent in this role of prices. It shows that the presence of a feedback effect from the financial market to the real value of a firm creates an incentive for an uninformed trader to sell the firm's stock. When this happens the informativeness of the stock price decreases, and the beneficial allocational role of the financial market weakens. The trader profits from this trading strategy, partly because his trading distorts the firm's investment. We therefore refer to this strategy as manipulation. We show that trading without information is profitable only with sell orders, driving a wedge between the allocational implications of buyer and seller initiated speculation, and providing justification for restrictions on short sales.