Before the current financial mess, investors and economists would air the question of whether the American economy and the world’s have “decoupled,” that is, whether they would no longer move strictly in tandem and one could hedge risks in the U.S. economy with investments in equities abroad. It was all speculation at the time, but now that markets are undergoing what may officially—and euphemistically—called a correction (10 percent drop in value), we can begin to answer that question: No.
Today’s headlines are filled with reports of carnage in overseas markets as the effects of the subprime mortgage “meltdown” (the preferred word, though debacle and fallout are often deployed) and ensuing credit crisis begin to spread everywhere. If you are wondering what the Indonesian economy has to do with people in Royal Oak, Michigan, and Elmira, New York, defaulting on home mortgages, the chain of events goes something like this, as far as I can figure it out. Once enough defaults were logged to make the CDOs and improperly-rated mortgage-backed securities seem radioactive, institutional investors (hedge funds, especially, it seems) that had taken on debt to leverage their bets in these risky markets suddenly needed to offload them, or found themselves having their collateral called in by their lenders. Sometimes this collateral was in the form of the bad mortgage securities themselves. So to cover margin calls and to preserve access to funds to cover operating costs, etc., big funds and investment banks, etc., had to liquidate whatever holdings they could manage to sell. But no one wanted the bonds (“asset-backed commercial paper”) anymore. That’s because no one knows which are likely to implode, because the subprime risk, on account of CDOs and credit-default swaps and general secretiveness on the part of big funds, has been so carefully disguised. (These are “informational asymmetries” in econospeak, and they stymie markets.) The markets had thus become illiquid, a dangerous financial situation that central banks tried to alleviate last week by pumping in money. And with markets not functioning, no one can use them to determine the price of various assets, which are essentially worth only what you can get for them. This suggests the scary thought that they may actually be worth nothing. And not surprisingly, this triggers panic.
So to deleverage, banks and big funds had to start selling assets that actually had been performing well in the “real economy”, in which growth is modest and stable and firms’ earnings are generally strong. But in a kind of collateral damage, the prices of these otherwise sound assets were driven down by the fire sale, and then this downward movement spooked other investors, who began fleeing the equity markets for safer environs—Treasurys, money markets, and the like. This prompts a kind of negative feedback loop. And because these price movements are not related to business fundamentals, they wreak havoc on funds driven by automated buying and selling—so-called quant funds. This all has sent American stocks on a roller-coaster ride, and has had a similar effect on equities abroad. Also affecting international markets is the havoc in forex markets, with the yen rapidly appreciating against a host of currencies. Why the yen? Because it is the favored currency to borrow in in order to participate in the carry trade— using cheap money borrowed in Japan to invest in high-yielding currencies elsewhere (New Zealand, Australia, etc.). But now, with the rush to unload debt, everyone must buy back yen to repay the loans, boosting its value. This unforeseen appreciation then affects the other Asian economies as well. And thus the trouble has made it everywhere. In the long run, these effects may be beneficial—the carry trade shouldn’t work, high-risk borrowers shouldn’t be lumped in AAA-rated securities, hedge funds shouldn’t be so secretive. But as is often noted, in the long run we’ll all be dead.