World stock markets have been on a roller-coaster ride in recent weeks. Defaults in the U.S. subprime mortgage market have rippled through the global economy, forcing central banks to inject liquidity into their banking systems as credit tightened. The jitters are another reminder of the interconnectedness of financial markets. Central bankers must keep a close eye on international developments and new financial instruments that create and amplify the connections between markets.

The recent shock waves began in the United States, when a growing number of Americans with subprime mortgage loans fell behind on their payments. Despite poor credit ratings, they had managed, courtesy of banks with excess capital and eager to find new markets, to get loans to buy homes. Other credit institutions wanting in on the action created securities backed by these loan portfolios. Low interest rates encouraged financial institutions to take out loans to buy the higher-risk (and higher-return) securities. Then, since this spring, as debtors predictably defaulted, a number of the original subprime lenders have reported liquidity problems that have spread to the holders of the debt-backed securities, both in the U.S. and overseas.

In recent weeks, the markets have realized that financial institutions once considered stodgy and conservative had embraced innovative investment vehicles that left them very exposed when the original loan holders could not pay up. Last month, Bear Stearns, a large U.S. investment house, was forced to close two hedge funds that lost more than $20 billion on mortgage-backed investments.