Krugman: The International Finance Multiplier

Paul Krugman develops an "international finance multiplier" that works through key leveraged intermediaries that connect countries together financially. His model shows that under capitalization, not liquidity is the main problem to be solved, and that "there are large cross-border externalities in financial rescues":

1. The International Finance Multiplier, Paul Krugman, October 2008: 1. Introduction The current financial crisis is remarkable in many ways, but one aspect is of special interest for international economists: even though the roots of the crisis lie in the U.S. housing market, the crisis is now very much a global affair. Figure 1 shows the decline in a number of stock market indices over the year ending October 4, 2008; essentially, all markets fell by the same amount.

The freeze on interbank lending and in the commercial paper market is affecting Europe to much the same degree that it’s affecting the United States, with the gap between Euribor and the repo rate similar to that between Libor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic.

International economists have been interested in interdependence for a very long time – arguably too interested. Global interdependence is one of those topics people love to talk about because it sounds sophisticated – the Wall Street Journal once published a piece mocking Multilateral Man, who wants to cooperate to improve coordination and coordinate to improve cooperation. (This is as opposed to Euro Man, who wants cohesion to promote convergence …)

But the interdependence this time is real – and it seems to be operating through channels that are not yet part of standard international macro analysis. Much thinking about international linkages still relies on some version of the traditional foreign trade multiplier: country A’s GDP affects its level of imports, which are country B’s exports, so demand shocks get transmitted through international trade. As I’ll explain shortly, however, this won’t work for current events. Instead 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. ...

Before we get there, however, let’s review the traditional analysis of interdependence.

2. Modeling interdependence

The granddaddy of all interdependence analyses is Romney Robinson’s 1952 paper, "A graphical analysis of the foreign trade multiplier." Robinson envisioned a two-country world with fixed exchange rates, fixed prices, and fixed interest rates, so that simple multiplier analysis applied. Home country GDP affected Foreign GDP through its effect on imports: higher Y led to higher Home imports, hence higher Foreign exports, hence higher Y*.

And Y* affected Y in the same way. So one had the picture of interdependence shown in Figure 2, in which HH shows Home GDP as a function of Foreign GDP and FF shows Foreign GDP as a function of Home GDP. A negative demand shock in Home would shift HH to the left, inducing a series of reactions that would reduce both Home and Foreign GDP.[2]

With floating exchange rates, the picture becomes more complicated, because shocks affect trade flows through the exchange rate as well as the effect of GDP on import demand. But trade flows remain the channel of influence.

The question is, how important is that channel? The fact is that in spite of globalization, trade flows don’t seem large enough to produce all that much interdependence. Figure 3 shows U.S. imports of goods and services as a percentage of rest-of-world GDP since 1980.

This share has roughly doubled, but it’s still fairly small. One way to think about this is to ask what it would take for a U.S. recession to impose a one percent of GDP negative demand shock on the rest of the world. For this to happen, U.S. imports would have to decline from 6 to 5 – a 17% decline. Given that the typical estimate of the income demand for imports is around 2, this would require a decline of more than 8% in U.S. GDP. So it would take an extremely severe recession in the United States to produce even a moderate-sized negative demand shock abroad.

But we’ve known for some time that trade flows aren’t the only source of international interdependence. The Asian financial crisis of 1997-1998 was notoriously marked by "contagion," the spread of crisis to economies with seemingly weak links to the original victims. In particular, the most severely affected nations were small economies that were not each others’ major trading partners, yet they experienced a dramatically coordinated slump. Figure 4 shows real GDP growth in the four "front line" economies; I think the figure speaks for itself.

And as the crisis spread, the linkages became positively baroque: Russia’s default seemed to cause a speculative attack on Brazil, and triggered a brief, scary liquidity crisis in the United States (at least it seemed scary at the time; by current standards it was a non-event.)

What was the explanation of global contagion? Some observers suggested that there were informational linkages – such as herding behavior by investors with incomplete information. Others, myself included, suggested that contagion was a sort of "sunspot" phenomenon: the afflicted economies were financially fragile, with the possibility of falling into a bad equilibrium always there, and the crisis atmosphere caused the descent.

The proposed channel that seems most relevant, however, seems to have been originally proposed by Calvo (1998): contagion through the balance sheets of financial intermediaries. Loosely, when hedge funds lost a lot of money in Russia, they were forced to contract their balance sheets – and that meant cutting off credit to Brazil.

An important paper by Kaminsky, Reinhart, and Vegh (2003) provided support for this view: it compared a number of episodes of international contagion, and found that all of the cases involved a "leveraged common creditor."

The argument of this short note is that an expanded version of the Calvo hypothesis is the best way to think about the global crisis now underway: essentially, all economies now share leveraged common creditors, so that balance sheet contagion has become pervasive. Today, we are all Brazilians.

Before we get there, however, it’s necessary to lay out a stylized account of the crisis.[3]

3. A minimal model of the crisis: single-country version

 

...[mathematical and graphical model]...

5. Implications

 

The story laid out here seems to have two main implications for policy in the crisis.

First, it suggests that the core problem is capital, not liquidity – or at least that you can explain much of what’s going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won’t do the trick. Instead, what’s needed is an injection of capital, which can’t reverse the original shock, but can undo the financial multiplier effect of that shock.

Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. Macroeconomic policy coordination never got much traction, largely because economists never could make the case that it was terribly important. Financial policy coordination, however, looks on the face of it much more important. Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial crisis. Multilateral Man, come home – we need you![6] ...

Comments

[Robinia]

Am hoping that I am getting this right, but, what it sounds like is that macroeconomic policy must always be larger in geographic scope than the largest source of capital-- or else a contraction in one place will echo in others, promoting the development of a vicious circle of contraction.

We could view this as a call for "Multilateral Man" to save the day (second coming of Jesus, anybody?), but, isn't trust-busting and progressive taxation to prevent large accumulations of wealth a more sustainable path? What did we learn about national capital controls in the Asian crisis?

[paine]

"the core problem is capital, not liquidity "

yup

"To the extent that this is true, rescue plans centered on making troubled assets liquid, like the Paulson plan passed last week, won’t do the trick. Instead, what’s needed is an injection of capital "

who sez uncle's just making a market here
to buy up forzen assets??
don't call for uncle
to use n hundreds of billions of public "capital"
to buy toxic paper assets
well below any conceivable
future market price those assets might fetch ???

oh ya even if we get rooked
we got options to participate in the equity upside...
just like warren buffet gets

i say check the fine print gang

[paine]

if we count our putitive externalities
and exchange numbers
we and the euros may convince
each other
to buy more junk

i like one calculation
using fiscal deficit spending
don't increase rest of world exports
in a very peppy way
even if you're
uncle buyer of last resort

[paine]

but uncle buying up tons of
trans nat paper crud
really might help our neighbors

that may enlist cosmopolites like anne
to the great bailorama cause

[anne]

What I have wished from the beginning is a combination of Swedish model, where the Treasury directly buys shares in troubled financial companies that cannot rely on private assistance, thereby immediately providing the capital base and security needed to continue credit flows, while a government spending program, much in the Japanese style, is begun to support employment.

I am fairly confident in such an approach in Europe, and sure of such an approach in Asia.

[don]

I think excess saving from Asia played a role. The yen carry trade and Chinese currency interventions created a large supply of loanable funds for intermediaries to peddle. Something like the so-called "LDC debt crisis" that emerged after the first surge in oil prices from '73-'80. Then, U.S. banks recycled petro dollars to loans in LDCs guaranteed by the local governments at rates less than inflation. Everything was fine until Paul Volcker raised rates to combat U.S. inflation and the LDC borrowers went bust en masse.

[Winslow R.]

Krugman wrote: "the core problem is capital, not liquidity "

Perhaps Krugman can take the next step and define 'capital'.

Tier 1,2 etc. and how they are created/destroyed and of course the 'gold standard' of capital, U.S. tsy secs/cash.

Many people, including most economists, need to know.

[killer]

What if the core problem of the immediate crisis is the walking dead institutions? Recapitalizing the walking dead financial institutions would prolong their demise and let them continue to frighten the other institutions with their demonstrated unworthiness. Nobody else will give them money, why should the government?

Buying toxic assets at low low prices would hasten the demise of the walking dead by exposing their deep insolvency. Living institutions are already getting money from stock offerings, Warren Buffett, and Mitsubishi. An institution that cannot raise money the old fashioned way should be put out of its misery.

Only provide capital to competent functioning institutions.

[anne]

What Krugman is referring to is having a secure and ample asset base on which to loan, which was assured between prime banks and industrial corporations in Japan during the financial crisis by emphasis on the significant mutual ownership that existed in Japan. Here the idea could be to have the Treasury as a temporary mutual owner of troubled financial companies to secure a capital base. Companies such as Goldman and Morgan Stanley and GE and even Wachovia are already being privately.

[anne]

"What if the core problem of the immediate crisis is the walking dead institutions? Recapitalizing the walking dead financial institutions would prolong their demise and let them continue to frighten the other institutions with their demonstrated unworthiness."

Precisely what was continually repeated in America and Britain about Japan during the financial crisis, and precisely the idea that the Japanese government rejected not wishing to have a mild slowing of growth turn to a terrible recession. However, if employment is of not account then let the suffering begin in earnest.

[don]

I wonder about a more fundamental issue - U.S. net foreign borrowing. It is not just U.S. imports that matter - it is the trade balance. If the U.S. exports more at the same time as it imports less, an amount equal to the 17% of U.S. imports that Krugman mentions can be reached quite quickly. The current U.S. trade deficit is over 5% of U.S. GDP (down recently from over 7%), which is a much bigger amount than 5% of U.S. imports. So eliminating the U.S. trade deficit would produce a bigger effect on trade partners than a 17% decline in U.S. imports. In fact, a reduction in the deficit to historic norms (2%-3% of GDP) would bring about such an effect. In my view, this would be devastating to Asian economies and to Germany's capital goods exports as well, with the result that the U.S. slowdown could be among the mildest.
What's stopping this from happening? Well, now that the U.S. homeowner no longer thinks he is so rich, the U.S. consumer is finally retrenching. But the U.S. government is stepping into the breach. I think a multilateral solution is needed, but one that does not depend on the U.S. playing Atlas.

[anne]

Mark Thoma:

"However, unless I've misinterpreted the results, this new model by Paul Krugman on the international finance multiplier makes it hard to argue that unique regulatory problems in the US could not have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

I have read this sentence several times now but am still not sure I understand what is intended. Is the problem my not reading well, or a tricky grammar?

[Winslow R.]

Don wrote "I think excess saving from Asia played a role."

Asia was saving U.S. tsy secs/cash (and to some extent Fannie and Freddies), the capital Krugman is talking about. Less capital for U.S. banks to leverage. Hence a systemic way to increase in leverage ratio was found through SIV's and hedgefunds.

If there is little capital and high loan demand, leverage increases (if unregulated) to meet the demand.

If 'capital' grows with loan demand, leverage can remain constant.

As leverage grows, ever smaller fluctuations in asset prices can topple the system.

Why doesn't 'capital' grow in proportion to loan demand to keep leverage constant? Blame the current monetary/fiscal policy tools.

[anne]

Would this be a little closer or have I completely botched the intent?

"However, unless I've misinterpreted the results, this new model by Paul Krugman on the international finance multiplier [suggests] that unique regulatory problems in the US could not have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

-- Mark Thoma

[Winslow R.]

My interp...

"This new model by Paul Krugman, on the international finance multiplier, implies unique regulatory problems in the US could have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

[anne]

Winslow:

"This new model by Paul Krugman, on the international finance multiplier, implies unique regulatory problems in the US could have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

Got it; and nice or so I think.

[anne]

I agree completely, Winslow.

[Mark Thoma]

Sorry if unclear - not first, or last time I'm sure.

Today, saw people claiming that it couldn't be regulation that caused the crisis because problems are worldwide, and regulation differs across countries.

Just trying to say:

Since interconnected, possible for US to cause problems everywhere, so a regulatory error here could show up as problems worldwide. So this claim isn't supported.

Did this quickly - not sure if that's any clearer.

[Note: rewrote that section, but not sure if better]

[Steve Kyle]

I am in agreement with much of this analysis but disagree that Paulson's plan cant work. Remember that Paulson's plan is designed to buy the mountain of impaired assets loaded up on the balance sheets of the financial institutions we want to save. IF we knew the current market price of those assets and only paid that much then the statement that the plan cannot work is correct.

However, if we OVERPAY for these assets then we are in effect recapitalizing the banks and not just providing liquidity. In other words, for the plan to work we MUST pay "too much" and to the degree that this happens we are actually providing capital and not just liquidity, and so the plan can work. (Or it can in theory if we overpay enough to recapitalize them as much as is needed)

However, we DONT HAVE A CLUE WHAT THE CURRENT PRICE is of these assets for the simple reason that we dont have a market in them. So we dont really know where the line is between liquifying them and recapitalizing them.

Fortunately, we dont need to know this. The bad assets are dead and we all know it, at least for the time frame that matters for the crisis. What will be essential is an accurate estimate of how much money will keep the chosen financial intermediaries afloat - How much is de facto recapitalization is something future economists can argue about.

[Steve Kyle]

On the regulatory relation with contagion - If the Europeans have stricter regulation then even if infected with the crisis, there should be less chance of each patient dying. If they get out of this with no or few failures, or without major institutions failing, then it will clearly be a case of regulatory failure here causing problems all over.

And the Brits dont count. They are more like us than the continental Euros are.

[killer]

Who gets recapitalized?

I still do not understand why anybody wants to recapitalize malfunctioning, unsound financial institutions? Why not kill them off?

How will eliminating failed, walking dead institutions catalyze a terrible recession or otherwise make the situation any worse? Many are doomed despite the bailout plan.

Why not only recapitalize sound institutions, that are also capable of functioning normally to acquire money from private sources?

Malfunctioning walki9ng dead toxic institutions might be screwing up the system even more than the toxic securities.

[Robinia]

Steve Kyle--
The bad assets are dead and we all know it, at least for the time frame that matters for the crisis. What will be essential is an accurate estimate of how much money will keep the chosen financial intermediaries afloat.

So, the CDS are just the "Emperor's New Clothes," and all is well as long as no pesky little kid mentions there is no there there? Funny way to fix an economy in a democracy-- might we not just as well fixate on some myth about sacrificing virgins to angry gods? Lotsa virgins (and other children, and the elderly, too) will be sacrificing plenty. And, it seems a lot less of complex model-and-institution revering, and a lot more truth-respecting, might be in order, no?

[don]

Winslow R.
"Asia was saving U.S. tsy secs/cash (and to some extent Fannie and Freddies), the capital Krugman is talking about. Less capital for U.S. banks to leverage. Hence a systemic way to increase in leverage ratio was found through SIV's and hedgefunds.
If there is little capital and high loan demand, leverage increases (if unregulated) to meet the demand."
High loan demand? Do you mean a shift in demand, or a movement along the demand curve, which could have been caused by lower real borrowing rates, caused by a greater supply of saving? My view was that the latter is the case - reinforced by the increase in asset values caused by lower real interest rates. The basic problem I am concerned with (unsustainable U.S. borrowing) is there with or without leveraging. The latter just brought the crisis to a spectacular head (an perhaps moved it up quite a bit in time).

[Steve Kyle]

three points

1. some of you guys seem to imagine that we can let the financial system fail and your lives wont be affected. That aint so, not even close. My heart doesnt bleed for bank stockholders but it sure does bleed for my own deposits, and my job.

2. There are times when you really DONT want to count up all the plusses and minuses and do a reckoning of exactly where things stand. There are lots of institutions out there that might be solvent in the long run but which are in negative space today. It is worth it to give them the chance to resurface.

3. It is entirely possible to figure out which instiutions are worth saving and then to recapitalize them in a way that lets the govt. (i.e. the taxpayers) share in the eventual profits. Or, we could simply tax them to recoup the money. Cynical statements about not wanting to bail out those jackasses may feel good but they wont get our economy back where it needs to be if we and our kids are going to have happy lives, with jobs, pensions, etc.

[Winslow R.]

Don wrote : "High loan demand? Do you mean a shift in demand, or a movement along the demand curve, which could have been caused by lower real borrowing rates, caused by a greater supply of saving?"

I'm saying lower real borrowing costs (which would increase demand) could have resulted from a greater supply of savings or higher leverage (or both). In this case, my guess is higher leverage was used to expand credit using the available savings (tier 1). There wasn't a 'savings glut' as much as an increase in the leverage ratio using unregulated off-balance sheet entities to expand lending capacity beyond regulatory constraints.

Don wrote:"My view was that the latter is the case - reinforced by the increase in asset values caused by lower real interest rates. "

I don't believe 'savings' (tsy secs) held by the financial sector expanded as much as this theory would suggest.

Don wrote: "The basic problem I am concerned with (unsustainable U.S. borrowing) is there with or without leveraging. The latter just brought the crisis to a spectacular head (an perhaps moved it up quite a bit in time)."

Borrowing is supported with income. As long as income is sustainable, debt is sustainable. I find income is supported through government spending, not necessarily deficit spending. Savings are supported with deficit spending. Both are important to keep the leveraged financial sector (monetary policy) from collapsing and sustainability is determined politically. If either fails to match the growth in the financial/real economy, the system collapses.

[Robinia]

HAHAHA-- the very idea of our KIDS having pensions! You must work in academia or the government, Steve Kyle. Nobody has PENSIONS anymore, for crissakes, let alone our KIDS having pensions.

Some serious restructuring is in order. Can't keep imagining that we will patch up the old scene we were used to and make it trustworthy again somehow. Time to look for financial intermediaries that are honestly working, and invest in them. No more investment banks, good! Why can't we recapitalize intermediaries through the Community Development Finance Institutions (CDFI) fund, instead of buying bogus derivatives based on liar loans? The infrastructure is in place, within Treasury. Why do we have to keep saying the only people who can handle this are the people who totally mucked it up? Give somebody else a chance, will ya?

[Robinia]

OK-- here is somebody important saying what I mean:

"We want a new world to come out of this," Sarkozy said. "We want to set up the basis for a capitalism of entrepreneurs, not speculators."

[don]

Winslow R:
"There wasn't a 'savings glut' as much as an increase in the leverage ratio using unregulated off-balance sheet entities to expand lending capacity beyond regulatory constraints."
?? Real borrowing cannot exceed real lending. Leverage just allows lenders to take responsibility for a greater value of transactions without putting much of their own skin in the game. Are you saying the debt would have been distributed to more responsible borrowers without the leverage? Or are you arguing that saving would have been curtailed by a drop in the return without the irresponsibility?
I thought the world was in agreement that the U.S. spending path was unsustainable.

[Mark Thoma]

Note: I decided to rewrite the intro. I dropped all the stuff about regulation because it detracts from the point of the model.

[Patrick]

"... IF we knew the current market price of those assets ... "

I hear Paulson has contracted Monsanto to build traders with a stochastic calculus burned into their cerebral cortex and generically inprinted ability to calculate Archimedean copulas.

[Winslow R.]

Don wrote: "?? Real borrowing cannot exceed real lending.
Leverage just allows lenders to take responsibility for a greater value of transactions without putting much of their own skin in the game. "

Answer:
Without a regulated leverage ratio, there is no limit to lending.

Example:
If you walk into Bank of America and ask for $700 billion, BofA has no problem coming up with the loan and deposit. What limits BofA is that the Fed requires an $1 in capital for every $10 in loans it makes. A 10x leverage ratio. $70 billion in capital would be required by the Fed of BofA.

Another Example:
A hedgefund, on the other hand, could have made the loan with only $14 billion in capital or 50x leverage.

Another Example:
Don's infinite leverage hedge fund makes a $700 billion loan to Paulson. Don has Paulson sign a loan contract for $700 billion and gives him a deposit account for the same amount which pays no interest. Everything is fine until Paulson decides to move $1 billion to BofA. Don better have access to the interbank lending market as he is going to have to borrow $1 billion from BofA at the current interbank rate. Hopefully he tacked on a point or two to Paulson's loan rate so he can make the BofA payment.

Don wrote: "Are you saying the debt would have been distributed to more responsible borrowers without the leverage? Or are you arguing that saving would have been curtailed by a drop in the return without the irresponsibility? "

With less leverage, fewer loans would have been made as loans would have been limited. Leverage expanded the amount of loans that could be made. I define 'savings' as government issued fiat currency (cash, tsy secs).

Don wrote: "I thought the world was in agreement that the U.S. spending path was unsustainable."

Only if it is unsustainable politically. What limits U.S. government spending? Politics, mostly in regards to inflation fears.

[JWhitland]

I feel more and more like an "avalanche patrol" approach is in order; that deliberately causing the least stable corporations to fail, on a daily or weekly basis, is the best approach to preventing larger scale disasters. Then I think, within that metaphor, what can be done to encourage large capital accumulations, without subsequent "avalanches"? Can we put in snow fences, or something to slow the movement of capital, to prevent massive unexpected capital flows? Maybe, although free-market economists hate the idea, we need to tax contracts, so that any time money changes hands, it is slowed down a little.

Perhaps a combination of regular explosive blasts (to shake up excesses) and fences are in order.

[I really wish that I could do something useful in reality except in metaphor land].

[Cent21]

Winslow, I think you have to add in the busted insurance sold, for example, by AIG and Lehman. And all the other derivatives, $60 Trillion worth, sold across international borders, so that lots of players could thread the needle of leverage and interest rates.

We went through a tipping point, and the house of cards blew past the mathematical models' limits.

Nobody was even able to assess counter party risk, save for a few people with a lot more information than the average joe-sixpack.

[hari]

What's imperative to macropolicy is the emergence of a globalized world of good and services, and America becoming the majour debtor country among OECD and emerging markets.

In other words, I've been repeating adnauseum multilateral cooperation is imperative to get a handle on global financial markets, since international credit markets are more or less offshore and SWFs are significant players for Treasury.

Paul is finally linking international trade to macropolicy and advising that country-specific criteria in framework of policy may no longer work - without global coordination. Yet the problem remains capital and lack of financial infrastrucure in emerging markets, in particular, to create
adequate credit markets of their own.

The Asean financial crisis was caused by lack of domestic credit markets - exclusive dependence on dollar denominated bonds and other commercial paper (Lehman's market in Asia!) for daily business transaction. When American dollar pulled out, the bubble was exposed!

So, going forward, international trade economists and other's must find ways and means to integrate domestic macropolicy with developments in global markets. This is easily said than done because we still have no formal coordination point of reference - as in OECD Secretariat, Paris - to intigate policy and fiscal reforms.

[hari]

spelling = instigate policy and fiscal reform.

[anne]

Mark Thoma:

Today, saw people claiming that it couldn't be regulation that caused the crisis because problems are worldwide, and regulation differs across countries.

Just trying to say:

Since interconnected, possible for US to cause problems everywhere, so a regulatory error here could show up as problems worldwide. So this claim isn't supported.

[Important and fine.]

[anne]

Mark Thoma:

"However, unless I've misinterpreted the results, this new model by Paul Krugman on the international finance multiplier makes it hard to argue that unique regulatory problems in the US could not have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

Winslow:

"This new model by Paul Krugman, on the international finance multiplier, implies unique regulatory problems in the US could have spread and caused problems worldwide, so I'm not so sure we can use the fact that the problems are worldwide to exonerate US regulatory errors."

That I initially had difficulty in understanding the sentence is no matter, and the sentence was well clarified, I think however that the point being made here is of special importance and should be included in the post.

[Doug]

The attempt to prevent any short-term pain at all will lead to a sure Gr8 Depression. But in the short term, politicians need to get elected.