(FORTUNE Magazine) – Been wondering about this whole economic "contagion" thing? The term, until recently found only in the odd economics working paper, has become the shorthand explanation for all the world's troubles. Bob Rubin talks about it. Wall Street strategists refer to it constantly. It's all over the business media. You may even have heard it at your last cocktail party.

It's a nice, scary metaphor--deadly infection spreads rapidly, from a bum loan in Thailand to global financial crisis. But how does it work? No one knows for sure, but the explanations offered by market types and economists fall into three categories: market psychology, market mechanics, and the vagaries of trade.

The wake-up call. When times are good, investors and lenders stop worrying about risk and focus on potential gain. Then something bad happens, they start thinking about risk again, and the whole structure of hope and greed that had driven the market up crashes down. Such sudden shifts in market psychology have been around as long as financial markets. What's new is that the same fund managers and bankers who got burned in Thailand also had money in Malaysia, Indonesia, and other emerging markets. And investors and lenders who don't have money all over sit in front of the same Bloombergs and read the same newspapers as those who do. Thailand's troubles caused investors to reevaluate the risks they faced all over the globe--particularly where economies and financial systems resemble Thailand's. Once they grasped those risks, they ran screaming.

The margin call. Psychology isn't the only reason a bond default in Russia can hit markets all over the world. The mechanics of investment matter too. Cross-border investing is largely the province of hedge funds and mutual funds, institutions that can seem designed to spread trouble.

Hedge funds leverage their investments, borrowing money from banks to buy, say, Russian government bonds. If the value of those bonds drops far enough, the bank calls in the loan. To raise the cash to pay back the loan, the hedge fund sells securities that are still worth something--i.e., securities from markets that haven't collapsed yet. If enough other fund managers are in the same fix, they can spark waves of selling all over the world, which in turn bring on yet more margin calls. Mutual funds don't use leverage, but when drops in one market hurt performance, they often have to raise cash in case retail investors want their money back. The way to do that is to sell securities from countries that haven't been hit by the crisis yet.

The real world. Market-based explanations alone can't explain how a crisis in Thailand more than a year ago is still making trouble all over the world. If the world's markets truly are an interconnected, borderless network, contagion should be transmitted instantly. But while a stray word from Alan Greenspan often is enough to send every market on earth shooting upward or downward for a day or two, the effects of such shocks are seldom lasting. What sticks is real economic adversity, transmitted across national borders by real economic ties.

If a country's currency is devalued--an essential element of the modern financial crisis--its trading partners suddenly find themselves at a great competitive disadvantage unless they devalue too. The Asian tigers hit hardest by Thailand's troubles don't actually trade all that much with Thailand; they do, however, compete with it in selling stuff to the rest of the world. So Thailand's currency devaluation quickly put pressure on its neighbors to either do the same or lose market share abroad.

What spread trouble to other continents was the effect of plummeting Asian demand on already weak commodity prices. The immediate impact on the U.S., Japan, and Europe was positive--a lot like a tax cut. But the price plunge has hammered exporters of oil and other natural resources: Russia can't pay its bills; Venezuela is in trouble; Canada, the No. 1 U.S. trading partner, has seen its currency slide.

It's the interaction between these different financial and economic forces that can cause really big trouble. The 1994 Mexican-peso crisis caused jitters in markets throughout the world, but its impact was limited because the economy of Mexico's main trading partner, the U.S., was strong and because prices for oil, a major Mexican export, were rising. So far in 1998, we haven't been so lucky.

--Justin Fox