Krugman: "We are all Brazilians now"

Balance sheet contagion rules the global economy. "Interdependence" is becoming a dirty word.

Published October 7, 2008 6:32PM (EDT)

One of the glories of our Internet-mediated information economy is that if we want the version of Paul Krugman's current economic analysis dumbed down for cable news consumption, we can quickly find it on YouTube, and if we want his thoughts smartened up for those who can handle some math, we can grab the PDF file directly from his blog.

As I've confessed before, I get lost at sea quickly when dealing with economist math, but unlike many dismal scientists, Krugman spices up his equations with remarkably colloquial language, so I think I get the gist of his "note" on the crisis: "The International Finance Multiplier."

Since 1995, Krugman observes, "there has been a major increase in financial globalization in the sense that there are large international cross-holdings of assets."

The asset-holders are, in general, highly levered, that is, they employ borrowed money to purchase whatever it is they currently own, like, for example, mortgage-backed securities.

When the price of an asset falls in one place, the shock quickly spreads across the globe. Falling asset prices lead to a process of "deleverage" -- as hedge funds and banks sell assets to raise capital to make good on all the money that they borrowed, or because investors in those hedge funds want their money back.

"...We seem to be dealing with a phenomenon I'll call the international finance multiplier, in which changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions."

The domino effect that the housing bust in the U.S. has had on financial markets all over the world is the most obvious manifestation of the international finance multiplier, but there have been previous instances of the same phenomenon. The most memorable may be the 1998 crisis in which Russia's bond defaults brought down the hedge fund Long Term Management Capital to its knees, and caused other, less obvious side effects -- "when hedge funds lost a lot of money in Russia, they were forced to contract their balance sheets," writes Krugman, "and that meant cutting off credit to Brazil."

"All economies now share leveraged common creditors," concludes Krugman, "so that balance sheet contagion has become pervasive. Today, we are all Brazilians."

And as if to accentuate the point, the latest news from the hedge fund world just gets gloomier and gloomier. I have zero sympathy for the wealthy investors who park their millions in hedge funds seeking exorbitant returns and who are now racing to pull their money out. But I can also see how this exacerbates Krugman's "international finance multiplier." September was one of the worst months ever for hedge fund performance, and massive redemptions are expected by the end of October. To raise capital to make good on those redemptions, hedge funds are forced to sell more assets. By selling more assets they create even more downward price pressure, here in the U.S., in Brazil, in Russia, and everywhere else.

I am definitely beginning to wonder whether the global economy can survive its own interdependence.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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Globalization How The World Works Paul Krugman Wall Street