Feedback effect in international markets?


While reading up on financial contagion, I saw that market crashes can actually get worse when other countries also can cause additional negative effects on the domestic market. How does this work????? I’m so lost. 🙁

In: Economics

With global markets highly interconnected, issues in once place can jump around fairly rapidly. These days, most investors try to diversify; they invest their money in a bunch of different types of assets (stocks, bonds, alternatives) in different sectors and in different countries. The idea is one asset, sector or region might take a hit, but it won’t kill you. However, if one particular region takes a big hit, it can force investors to have to sell good assets for liquidity (they need cash) or to try and rebalance their portfolios. They also might stop investing altogether, thinking that holding cash is the safer bet. So even though the problem is in “Asset A” declining, I have to sell some of unrelated “Asset B”. Because I sell, “Asset B” might decline, and some other investor in “Asset B” might need to sell “Asset C”. It creates a feedback loop: selling leads to more selling.

Where this was a big problem in 2008 was in commercial paper: short term debt companies rely upon to to fund daily operations. Generally speaking, it’s considered very safe. In 2008, however, when banks like Lehman Brothers went under or came close, people who had lent them this short-term debt suddenly were looking at big losses on an investment they considered very safe. Suddenly, liquidity dried up in commercial paper markets; no one wanted to own the paper of the next Lehman. Companies that were in perfectly fine shape–there was little to no risk they’d default on this debt–could not get the short-term loans they depended on to fund regular operations. An example: large McDonalds franchisees were at risk of not being able to pay their employees because the commercial paper markets grinded to a halt. Businesses like this were not necessarily the cause of the financial crisis, but they were still impacted.