Managing Globalization

When one of the world's big economies stumbles into a quagmire, as the United States has with the subprime mortgage crisis, investors and borrowers always start asking how they got into such a mess - and how they will get out. These days, the effects of globalization provide a partial answer for both questions.

Globalization has added risks to the world's financial markets, but it has also created connections between economies that may add stability when one of them feels a jolt. In the future, financial regulation may even help to reduce those risks while preserving the benefits of interconnectedness.

In the case of the current crisis, the idea came first: bundle high-risk mortgages in a way that made them more liquid and preserved their high returns. It caught on quickly. Low interest rates and the unification of the world's credit markets had made credit easily obtainable, and financial globalization meant that investors everywhere could pour their money into the same kind of asset.

"There's been a lot of money sloshing around the markets looking for a place to be parked, not only because of the Fed but also because of what's been happening in the rest of the world," said Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley. "It fed the securitization of mortgages and all kinds of other liabilities."

Yet during this period, as investors and banks in the United States, Europe and other regions bought up the complex new securities, some people who were ill-equipped to judge the risks got involved, often assuming that the rating agencies' assessments were enough.

In addition, it became more difficult to figure out where, in the global credit market, the risks really lay. "It's become more delocalized," said Raghuram Rajan, a professor of finance at the University of Chicago. "You don't borrow from your neighborhood bank anymore, you don't deposit in your neighborhood bank. You invest more widely, and you invest through a whole group of intermediaries."

Furthermore, Rajan said, a herd mentality that might have been confined to one country market before can now spread around the world, magnifying the risks of a sudden shock.

"When we all get into the same kinds of assets or the same kinds of trades at the same time because they've been lucrative, we all fall down at the same time," he said. "In fact, there may be some incentive to all fall down at the same time, because then none of us takes the blame."

In the aftermath of a crisis, however, the interdependence of the world's economies can help to alleviate some of its worst effects.

For example, Eichengreen said, an economic downturn in the United States could be mitigated by the relatively strong growth in Europe and Latin America. "They are still going to be a sponge for our exports," he said. "That's going to be an important stabilizing force for us."

Still, the rest of the world is likely to suffer if the situation in the United States gets much worse. "The fact that so many economies are still dependent on U.S. demand, and haven't grown their own domestic demand, will cause some problems," Rajan said.

Even China's strong growth may not provide enough support to stop a global slowdown. "I don't believe that China has become a growth pole independent of the United States," said Eichengreen. "If we go into a recession, their growth is certain to slow as well."

That might not be so bad for China, where worries about inflation and overheating continue to deepen, but few other places would welcome that sort of drag on their growth. So what can be done to deal with the problem of a risk wildfire before it starts?

Rajan said old-fashioned due diligence, like getting banks to monitor the activities of the funds that borrow their money, could help. He also suggested changes in incentives for investment managers: "What you can do is ensure that there are voluntary agreements that the incentive structures will have elements that are long term. If I've got 20 percent of my wealth riding in the fund that I manage, then I'm a little reluctant to do the carry trade for too long. It could close up."

But Eichengreen said the risks to the financial system justified regulation, and on a global scale.

"We have the institutions for the coordination," he said. "We have the Basel committee of bank supervisors. We have the International Organization of Securities Commissions. We need to push them to act more aggressively and more forcefully, and put a little less faith in the ability of the markets to solve their own problems."