The international finance multiplier

Back in the day, economists used to talk about the foreign trade multiplier — international business cycle linkages via flows of goods and services. The basic idea was that since one country’s imports are other countries’ exports, a recession in one country would be transmitted to the rest of the world as slumping demand here led to an export plunge abroad.

That’s not what’s happening now, or at least not yet. We’re experiencing a global crisis, but a different kind of linkage is at work — call it the international finance multiplier. It operates through the balance sheets of highly leveraged financial institutions, which do a lot of cross-border investment. When these institutions lose heavily in one market — say, US mortgage-backed securities — they find themselves undercapitalized, and have to sell off assets across the board. This drives down prices, putting pressure on the balance sheets of other HLIs, and so on.

And so a crisis originating in Florida condos and San Diego McMansions is causing havoc for Greek banks. Financial globalization, it turns out, means globalized financial crises.

I’m writing up a little model of how this works, coming soon.

Comments are no longer being accepted.

Chris October 5, 2008 · 8:37 pm

As this is a crisis in mortgage backed securities (largely), where confidence has eroded in the soundness of the securities that are derivative of the mortgages, wouldn’t there be some sense in making ALL mortgages easier to pay off and restore confidence in the MBSs. this could create a functioning auction market for the securities and alleviate the governments role.

How about lowering mortgage rates to 4%. This would create some confidence in the fact that mortgages would be repaid, albeit not to the original value, and also be a de facto stimulus plan, as every mortgage holder would have additional cash in their pockets. Can someone explain why this wouldn’t work?

Except of course for throwing contract law out the window.

This

Benoit Essiambre October 5, 2008 · 8:57 pm

premise one: In the long term, a well diversified global portfolio always has positive growth.

premise two: Maximizing returns is achieved by leveraging as much as possible those investments in sectors that are guaranteed to grow.

conclusion: profit!

Nothing can go wrong right?… right???

Seriously, what if there was this value, based on a global expectation of future growth. A value that has been reflected in the price of credit, the price of equity and of investments in general (including pension funds etc), especially the more complex investments. And what if given, high oil and commodity prices and high global population, the market is suddenly realizing that we simply can’t sustain this kind of growth, especially in terms of real growth per person. Wouldn’t that mean that the real value that all these investments and salaries were based on isn’t there anymore or that it has simply never existed?
No amount of government intervention, bailouts or movements of money is going to change the fact that we can’t make real value appear by magic. Globally the market seems to be noticing that there is a oversupply of humans and an undersupply of natural resources. In my opinion, the average price of human labor has to go down as does the average price of investments that are based on the product of human labor. Government bailouts may help deleverage banks and struggling institutions, but only while leveraging the government by an equal amount(!) Bailouts are probably still marginally useful since there is a certain urgency in the problems with banks. The banking system poses immediate dangers and it is probably less critical for the government to deleverage as quickly. However in the long run, the lack of value is going to have to be distributed to people. Either through government taxes, inflation, or by a significant amount of people having pay cuts. I think the government will never be able to fill this void. The best it can do is try to help it be distributed more fairly and more efficiently.

Don the libertarian Democrat October 5, 2008 · 9:09 pm

The Swedish, Icelandic, Dutch, And British Plan

The Swedish Plan, via the NY Times:

“That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

“If I go into a bank,” said Bo Lundgren, who was Sweden’s deputy minister of finance at the time, “I’d rather get equity so that there is some upside for the taxpayer.”

The Iclelandic Plan, via Paul Krugman:

“Iceland has just bailed out Glitnir Bank, with the government putting in 600 million euros — $859 million — in return for a 75% stake.

Iceland has only a bit more than 300,000 people, about 1/1000th the population of the United States. So this was, per capita, the equivalent of an $850 billion bailout here.

Notice, by the way, that it was an equity injection rather than a purchase of bad debt; I approve.”
The Dutch Plan, via Calculated Risk:

“The Dutch government on Friday re-negotiated last weekend’s bail-out of Fortis in order to buy all of Fortis’s Dutch operations for €16.8bn, including its Dutch insurance operations and the Dutch operations of ABN Amro…”

The Dutch government will privatise the Fortis and ABN Amro operations after calm returns to the markets, it said. Nationalize. Then privatize. That is a proven approach. It will be interesting to see if the Dutch approach works better or worse than the Paulson plan. ”

The British Plan, via Calculated Risk:

“Alistair Darling, the Chancellor, could give the banks billions of pounds in return for shares in an emergency bailout plan to be enacted if the financial crisis worsens, The Daily Telegraph has learnt…”

This is more like the Swedish solution, or the RFC in the U.S. during the Depression, as opposed to the TARP. ”

It will be interesting to compare these results with TARP.

Ralph October 5, 2008 · 9:16 pm

What I’m not sure about is the degree to which the health of “highly leveraged financial institutions” ought to influence everyday commerce.

Since non-bank financial firms have been participating in transactions which might earlier have been taken place within the traditional banking system, should we now move those transactions and associated asset accounts back into the “real” banking system?

Is there some way that process can be accelerated?

FairEconomist October 5, 2008 · 9:33 pm

Not to disagree with your model – crossborder contagion is certainly happening – but there are a lot of bubbles besides US housing. There’s several real estate bubbles in Europe, another in China, bubbles in retail, auto loans, and credit cards in the Anglo countries as well as some others (Iceland is a case in the news; I’m sure there are others). Some of the collapse will happen from lagging markets anticipating leading markets. England is going down pretty fast compared to the US, for example. Many European banks haven’t taken losses from Spain/Ireland/Poland *yet* but everybody knows they are coming. There are global origins as well as global contagion.

skeptonomist October 5, 2008 · 10:04 pm

Imagine what a joke physics would be if the basic principles had to be re-learned every generation. Can’t some of the basic economic principles, such as “what levers up, must lever down” somehow be transmitted through education?

QuasiEconomist October 5, 2008 · 11:15 pm

What was Paulson thinkng when he let Lehman fail? Much of the recent trouble originated from that decision. I am an economist and teachers always emphasized on two things:
a) People will make fun of you for being an economist and
b) Never, ever play brave with the financial system. If it needs to be saved, save it or let someone else take your job.

I am surprised international officials familiar with these type of crisis haven’t been consulted like say, ex President Zedillo from Mexico. He masterminded the bailout plan in ’95 and the banking system is now strongly regulated and more capitalized than ever.

This is not the first time this situation happens in the world, the US should take advantage of officials from emerging markets who have faced this problems in the past.

Arin D October 6, 2008 · 12:57 am

Paul,

I get your argument about financial linkages through balance sheet effects. However, here’s one question I have which I’d like to see you (and the economics community more generally) adress …

While it is relatively clear to me how the bursting of a bubble in the US can affect financial institutions in Europe (directly and indirectly), I’ve yet to hear any good argument about why we saw correlated speculative bubbles in real estate in US and Euroland. One explanation is low real interest rate globally; and this seems right as low cost of borrowing is a necessary condition for bubbles. However, it is in no ways sufficient as many other episodes exist with low real interest rates that haven’t produced bubbles.

Moreover, country-specific deregulation seems a weak explanation when we have to explan cross-country correlation. Perhaps, the explanation is global in nature – it’s not deregulation in the US (or particular countries) per se, but rather a relatively deregulated globabal financial market where most investment decisions are based on knowledge that is extremely fragmented and non-local in nature. In other words, there is a greater disjuncture between local information sets about investment opportunities and the sources of supply of funds. In light of the imperfect overlap in information sets and sources of funding, financial market integration may lead to greater possibilities of bubbles at a global scale.

After all, since the early nineties we have had roving bubbles across the international financial landscape, often though not always related to real estate. (Japan real estate bubble, Thailand real estate bubble and then three other East Asian countries, US tech bubble , US real estate bubble, EU real estate bubble.)

So perhaps we need to really look at theories that take the global market linkages as the key ingredient (as opposed to country based explanations) to get a handle on the bubble dynamics…

Arin D

Winslow R. October 6, 2008 · 2:07 am

Please include how tsy secs have become the ‘new gold’ of the fiat credit based financial system and are therefore necessary for the recapitalization of the system.

Removal of this ‘new gold’ during the Clinton surplus along with insufficient deficits during recent times has led to a ‘new gold’ shortage. Massive current account deficits exported our ‘new gold’ throughout the globe more rapidly than it was being created, leading us into this mess.

cheesenstein October 6, 2008 · 2:19 am

Proving once again that the market is an ecosystem — and it needs to be stewarded.

milvio diaz October 6, 2008 · 2:23 am

Have you or can you put into numbers the origin of this crisis? In the past two days I have been reading comments accusing the Clinton Administration of initiating this crisis due to their request that Fannie Mae and Freddie Mac increase loans to lower income people.

LiveFreeOrDie08 October 6, 2008 · 4:07 am

Dr. Krugman,

I have yet to fathom how leveraging works in general when the ratios are excessively high (30x) as we have seen. It appears that the system relies on the continued appreciation of the “base” asset. Is there any provision in this economic model for a retraction or depreciation of the base asset? If not, wasn’t this a doomed model from the start?

just john October 6, 2008 · 7:31 am

By the way, I’ve figured out a use for all those empty McMansions sitting in the middle of nowhere: Prisons. They could each hold a couple dozen inmates.

Allison Keefer October 6, 2008 · 8:20 am

The storyline I hear by the Republicans is that this financial crisis is the fault of the Democrats who insisted (in 2004 requirement) that all minorities be given loans that they couldn’t afford. Of course, they would default. Could you speak to this event and how the global financial crisis was caused by the Democrats (tongue in cheek, please!)?

Michael Ryan October 6, 2008 · 8:26 am

Paul,

Every conservative talking head on TV has been claiming that the meltdown is the fault of minorities not repaying the mortgages that lenders were forced to extend as a result of the Community Reinvestment Act. I see them make this claim time after time on TV without rebuttal even though I find other sources that state with strong supporting evidence that CRA is not the root of this crisis. Can you share your views?

Mike.

kharris October 6, 2008 · 8:46 am

I think your comment demonstrates the traditional notion that we can usefully look at international financial transactions at the level of the nation-state. Perhaps the appropriate point to make at this time is that the influence of borders and nation-state policies is far smaller in finance than in trade. From the piont of view of the credit markets and of individual international financial firms, the notion that “our books are in trouble in country A so we need to sell assets in country B” is mostly wrong. The firms will ask themselves “what assets should we sell?” without much thought about geography. If analysis focuses much on geographic separateness, it will be wrong.

joseph kruzich October 6, 2008 · 9:27 am

Could you address the column in today’s Washington Post by Sebastian Mallaby on the origins of the financial crisis not being over-regulation, but rather Chinese exports creating a pool of money that sloshed around in financial markets and created an asset bubble. Also, he notes that Fannie and Freddie were forced to buy a third of toxic mortgage securities to encourage home ownership. He puts the fault at the doors of the fed for not attacking the asset bubble, but i think he is missing key deregulation on leveraging and other issues that allowed this to happen. This is an alternative narrative that seems to have some supporters, but it doesn’t seem accurate and I just wanted your take on this. It is important that the narrative on this crisis be right, so that the solutions to prevent the future addresses the real issues. thanks for your thoughts.

Gerald Bratcher October 6, 2008 · 10:34 am

Well, here is nearly a solution. One that I think is pretty damned good. And it doesn’t cost taxpayers a penny.

Regarding “Credit Default Swaps”. As near as I can determine there are about five trillion dollars of these in the world that represent a true hedge against a loss of an asset that is held by the hedger.
Then there are about 65 Trillion dollars worldwide that are like a “naked short” that are a purely speculatiive bet on an asset (mostly corporate paper) going belly up. They don’t own the underlying asset they are betting on. And this has two important consequences. One, there is 65 trillion dollars at stake with the interested beneficiary only winning if it goes bust. Two, he has no losses if it goes up (other than his minor CDS fee). A short seller that guesses wrong can lose everything. A CDS buyer loses about one percent. This is poisonous. And it probably violates laws against “gambling” in the US and almost every state.
So, pass a Law, emergency please, cancelling or outlawing all naked Credit Default Swaps. Let the true hedges survive, but strictly under the terms of their contracts. Most such bets won’t pay off (which will bother the holder of the CDS not at all as he owns the underlying asset) and some of those that should pay, won’t, as the issuer will go bankrupt. Too bad for him. To bad for the buyer, buying from an inadequately capitalized issuers.
Economy saved. Nation solvent.

Jeremy, from Iowa October 6, 2008 · 10:42 am

Dr. Krugman,

Would you write in your blog about China’s dollar reserves and what probability you think their may be that they dump dollars? I’ve read elsewhere that because they have so many dollars, they hold significant power over us and could destroy our currency if they wanted. I’m curious what would bring them to do that and if you think that’s at all likely or possible? I don’t see much on this in the news, but I would like to learn more about it. You seem like the person to ask.

From Iowa

gVOR08 October 6, 2008 · 10:53 am

The Republicans are claiming the bad mortgages are in minority neighborhoods where liberals forced the banks to quit redlining. Paul K says FL condos and San Diego McMansions. I believe the latter, most of my friends the former. Is there any solid information on the nature of the bad mortgages?

(Whatever they are, nobody told the financial institutions to leverage them 40:1.)

Justin Loe October 6, 2008 · 11:03 am

Mr. Krugman,

What alternatives exist to stabilizing the CDS market and preventing a wholesale systemic collapse? I’ve read today that the Fed is considering multiple options for providing credit to banks in light of the credit market collapse.

Would a nuclear option consist of some sort of freeze or abolition of the CDS market? If that is naively unwise, what do you suggest to address the looming CDS crash?

creid October 6, 2008 · 11:22 am

OK, here’s a question for you:

Housing based derivatives depend on income streams for profitability. Thus, decreased interest rates and/or forgiveness of prinipal would seem to kill the goose that laid the golden financial egg, while protectiving the family for whom the house is its nest-egg.

Is this the reason why there was no relief for homeowners in the bailout package? Do the derivaties force a triage type decision: who or what in the lifeboat do you save?

I just don’t see how you can provide relief to homeowners and not unbalance the already unsaleable MBS and other derivatives. At present, risk is hypothetical; if a clear homeowner rescue package were done, then risk might be much more quantifiable.

Am I missing something — would a rescue plan for home mortgages have made paying too much for assets much harder for Paulson? And how would it have impacted the market for securities that may have been based not on responsible payoff of mortgages, but simply a modeled percentage of an incremental, regular stream of payments for as long as possible?

dave October 6, 2008 · 11:33 am

Professor Krugman, spend the weekend with a friend who went to Canada 40 years ago, & he says Canada isn’t having any problems because it has only five banks country wide & because mortgage interest isn’t tax deductible. Is he right that the Canadians are immune? If so, why?

DH October 6, 2008 · 11:54 am

So why could not the G7 print money to expand the monetary base in a coordinated fashion to recapitalize the system. This would be inflationary, of course, and drive up the price of some commodities like gold. But it would devalue all debts in an economic space that accounts for >80% of world GDP If it was coordinated it would be different than any one country, say the US, printing and devaluing, so it could have a smaller impact on worldwide trade than a unilateral run of the printing machine. And it’s not like EU, China or Japan will decouple easily.

drymocke October 6, 2008 · 12:21 pm

This is what I’ve been able to research. The mortgages that are failing, it seems to be across the board, value wise. I look at local foreclosure sales as well as those pending foreclosure. 1 McMansion seems to be equal in value to 6-8 low income houses. But way fewer McMansions ever reach foreclosure as people are buying them directly from/through the banks holding the current mortgage at a discount. Most of the low income places end up at auction because no one reaally wants them except at firesale prices.