The result I mentioned earlier – that tight international linkages do not necessarily strengthen the case for international policy coordination – holds for what I would define as “normal times”. In Obstfeld and Rogoff’s words it holds “unless risk aversion is very high”. 4 In the current generation of theoretical models, risk aversion is generally considered a constant parameter.
This was what transpired in the United States – low federal funds rate fueling a boom in mortgages with borrowers having doubtful credit histories, housing prices bubbled and burst, with the negative feedbacks affecting both the U.S. domestic economy and financial markets. Another example is in line with risk spreading through financial innovations. The ability to spread risk should also be a desirable goal.