Global dimensions of the crisis

Paul Krugman modelled the crisis here, claiming that an "international finance multiplier" has been responsible for transmitting changes in asset prices internationally through their effects on the balance sheets of highly leveraged financial institutions. He writes, "when hedge funds lost a lot of money in Russia (or US), they were forced to contract their balance sheets – and that meant cutting off (or pulling out) credit to Brazil (or India)." He claims that the present crisis can be addressed only by co-ordinated fiscal and monetary actions by all major global economies, so as to inject liquidity into the markets and thereby undo the financial multiplier effect of the market shock.

More than macroeconomic policy co-ordination between national governments during recessionary times, financial policy co-ordination during times of turbulence in financial markets assumes great significance. As Krugman writes, "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."

The multiplier effect is transmitted through, what Kaminsky, Reinhart, and Vegh describes as the "leveraged common creditor". Prof Krugman therefore argues that since all economies now share leveraged common creditors, balance sheet contagion has become pervasive. This effect has been magnified in recent years by a major increase in financial globalization in the sense that there are large international cross-holdings of assets. As the chart below shows, both the rest-of-world (ROW) assets in US (red) and US assets in ROW (blue) have surged in recent years.



Barry Ritholtz blames the Fed for causing the housing crisis, both by ignoring lending standards and by keeping interest rates too low for far too long. He feels that during the 2002-07 period, the basis for mortgage lending was not the (traditional standard of) borrowers ability to pay - it was the lender's ability to securitize and repackage a mortgage.

He writes about the "Greenspan put", as part of which the Fed "maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004), a 1.25% for 21 months (November 2002 to August 2004), and lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June 2004)". The crisis spread worldwide, thanks in large measure to the import of American "best practices" by others - ultra low rates, securitization, and "innovative" lending standards.