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.
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. A minimal model of the crisis: single-country version
...[mathematical and graphical model]...
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! ...