Why Markets Tumble Together

"Bonfire of the currencies." "Meltdown!!!" "Fear of falling." "Global margin call."

Economists and journalists are using such terms to describe the plunge in currency values and stock market prices that rumbled around the globe in the wake of Russia's recent devaluation of the ruble.

Financial fears are spreading. But behind the concerns - some real, some imagined - lie important lessons about the growing interdependence of the world economy on the cusp of the 21st century.

One is that, no matter how bush league one part of the world's economy may seem, it can still cause financial panic elsewhere in an era when money and capital flow around the globe at the click of a mouse.

Take Russia. It buys less than 1 percent of US exports - about the same as Denmark. Yet it is causing worries from Germany to Brazil. Indeed, all the emerging economies of the world account for only about 17 percent of global output, and not all these are in trouble. Japan, whose economy is in the doldrums, makes up about 18 percent. So at most, one-third of the world's economy is in recession.

"The entire globe was in recession in 1974-75," writes Michael Cosgrove, a Dallas economist, in a monthly report, The Econoclast. "The world didn't end."

Most economists still expect that Western Europe and North America - where economies are still growing and which account for two-thirds of world output - to prevent a global recession.

But there is concern that Russia's woes, in particular, could spread to Latin America and beyond. Economists offer several explanations for the turmoil:

* Fear What's going on globally is, in effect, like a run on the bank. Losing confidence, investors in the United States, Europe, and other countries have rushed to take money out of stock markets in both developing and industrial countries. They have been putting it in more stable financial havens, such as government and corporate bonds in the US.

Wall Street is calling it "a rush to quality." In the US, the Dow Jones Industrial Average was down 6 percent last week. In London, stocks fell 5.5 percent, in Mexico 7.6 percent, in Warsaw 16.7 percent, in Manila, 9.7 percent. Japanese stocks lost $241 billion in value, an amount exceeding the entire output of Russia.

Unlike in a nation, there is no central bank for the world to act as "lender of last resort," capable of creating vast amounts of credit to cover withdrawals in a run on financial institutions. The International Monetary Fund (IMF) can put together rescue loan packages for a nation. But its resources are limited.

* An excuse. Many US investors are really more concerned about other factors than Russia. They regard stocks as overpriced, but were happy riding along in the bull market. Now they are concerned that emerging market and Japanese economic troubles will spread to Latin America and hit the US economy harder. The Russian devaluation acted as a trigger for those who wanted to pull out anyway.

"Those who believe that the US is somehow immune to global contagion will be unpleasantly surprised," says Bruce Steinberg of Merrill Lynch & Co. in New York.

Further, they see corporate profits slipping. The Commerce Department last week said after-tax profits slid 1.5 percent in the second quarter from a year ago.

* A fault in capitalism. When the present international monetary system was set up in 1944 at Bretton Woods, N.H., those attending didn't envision a world where capital could shift across borders freely. Most nations imposed controls on capital movements after World War II.

Money that knows no borders

In the last 10 or 20 years, though, many developing countries have joined the industrial nations in allowing free capital inflows and outflows as well as more liberal trade policies.

This "globalization" of the world economy was welcomed. It brought direct investment in plant and equipment, modernization, and money for expansion. Indeed, private capital flows into emerging markets topped $232 billion last year.

Now globalization is seen as having a bad side. Money can leave even faster than it came. This result is a fire sale of currencies. They fall in value as investors look to exchange their money for more stable currencies - say, rubles to dollars.

Banks and companies that have borrowed in dollars and other hard currencies, and then loan them out in rubles, are left in the lurch. Repayments of these loans become difficult. Weaknesses in the financial system, such as inadequate capital or risky loans, become magnified. Nations - such as Thailand, South Korea, and Indonesia - undergo a severe slump.

At the moment, leaders of industrial nations and such key multilateral institutions as the Washington-based IMF are at a loss on how to tackle the crisis.

They deny any need to reimpose controls. They say troubled emerging nations must fix up their banking systems and carry out other financial reforms to bolster international confidence.

That process, they admit, may take a year or two. Meanwhile, these nations will suffer severe recession or worse. And there will be danger of the crisis spreading in the world.

But some analysts see the economic punishment as being too severe for the reforms that are needed. They suggest that restrictions on short-term capital movements be put back in place.

In effect, Russia did that last month when it imposed a 90-day moratorium on repayment of short-term debts and stopped supporting the ruble on foreign-exchange markets.

The action had an echo. It made investors anxious about investments in other emerging markets, sending stocks plunging in Eastern Europe and Latin America.

Lower interest rates on the way?

In the US, pressures are building on Congress to pass legislation that would provide the IMF with more funds to deal with the crisis. There is also more talk of the need for the Federal Reserve to cut short-term interest rates to stimulate growth and revive stock markets in the US and abroad.

"The only way to avoid further economic problems is for the Fed to lower interest rates and increase dollar liquidity" in the world, writes Brian Wesbury, chief economist for a Chicago brokerage firm, Griffin, Kubik, Stephens & Thompson Inc. Such a move, he says, "would sharply reduce the market's overvaluation and could be salvation."

Stocks and bonds are always considered competitive investments. If the interest rate on bonds moves lower, stocks become more competitive. Stephen Roach, chief economist of Morgan Stanley, a New York brokerage house, says he is now thinking the "unthinkable." He puts a 25 percent probability on the Fed lowering interest rates in the next 30 days.