One of the arguments that I make in Globaloney 2.0 is that the risks of international finance were systematically ignored or “misunerestimated” as a former President might have said. I call the false belief that international finance is fundamentally safe and sound “Financial Globaloney.”

When you take even relatively safe domestic investment patterns and add to them the instabilities and uncertainties of international currency markets, I argue, the risks rise exponentially. When those investment are highly leveraged, as they usually are, the risk profile explodes.

The good folks at the Financial Times have produced an excellent brief presentation that explains the “carry trade” (which my students will recognize as an example of “naked interest arbitrage”), showing both why this investment pattern would seem “safe as houses” and why it can go so badly wrong.

Click here to go to the FT carry trade site. (Note: you will need to register — it’s free — to view the article.)

The bad news is that the carry trade, which unwound during the bust, is leveraging up, with the U.S. as the low-interest source of funds. That’s why the dollar keeps falling — investors borrow dollars and sell them to get currencies that earn higher interest.  That’s why it has been so difficult to talk the dollar back up — you’d need to raise U.S. interest rates or bring down foreign rates to lessen carry trade flows.

The carry trade collapses during a crisis. Everyone rushes to cash out and bring their money home. That’s why a surge in the dollar would be bad news for the global economy — it would probably be associated with another seismic financial shock.