Financial crisis

For the 2008–2009 crisis, see Global financial crisis of 2008–2009.

The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.

Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

Types of financial crises

Banking crises

Main article: Bank run

When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits (see fractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a systemic banking crisis or just a banking panic. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called a credit crunch.

Examples of bank funds include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. The collapse of Bear Stearns in 2008 has also sometimes been called a bank run, even though Bear Stearns was an investment bank rather than a commercial bank. The U.S. savings and loan crisis of the 1980s led to a credit crunch which is seen as a major factor in the U.S. recession of 1990-91.

Speculative bubbles and crashes

Main articles: Stock market crash and Bubble (economics)

Economists say that a financial asset (stock, for example) exhibits a bubble when its price exceeds the present value of the future income (such as interest or dividends that would be received by owning it to maturity). If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur.

Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000-2001, and the now-deflating United States housing bubble.

International financial crises

When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency because of a speculative attack, this is called a currency crisis or balance of payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight.

Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992-93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997-98. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.

Wider economic crises

Main articles: Recession and Depression (economics)

Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. Since these phenomena affect much more than the financial system, they are not usually considered financial crises per se. But some economists have argued that many recessions have been caused in large part by financial crises. One important example is the Great Depression, which was preceded in many countries by bank runs and stock market crashes. The subprime mortgage crisis and the bursting of other real estate bubbles around the world is widely expected to lead to recession in the U.S. and a number of other countries in 2008.

Nonetheless, some economists argue that financial crises are caused by recessions instead of the other way around. Also, even if a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve, and Ben Bernanke has acknowledged that he agrees.

Causes and consequences of financial crises

Strategic complementarities in financial markets

Main articles: Strategic complementarity and Self-fulfilling prophecy

It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. George Soros has called this need to guess the intentions of others 'reflexivity'. Similarly, John Maynard Keynes compared financial markets to a beauty contest game in which each participant tries to predict which model other participants will consider most beautiful.

Furthermore, in many cases investors have incentives to coordinate their choices. For example, someone who thinks other investors want to buy lots of Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen too. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw too. Economists call an incentive to mimic the strategies of others strategic complementarity.

It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crises are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so.

Leverage

Main article: Leverage (finance)

Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial institution (or an individual) only invests its own money, it can, in the very worst case, lose its own money. But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another (see 'Contagion' below).

The average degree of leverage in the economy often rises prior to a financial crisis. For example, borrowing to finance investment in the stock market ("margin buying") became increasingly common prior to the Wall Street Crash of 1929.

Asset-liability mismatch

Main article: Asset-liability mismatch

Another factor believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reason bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Likewise, Bear Stearns failed in 2007-08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities.

In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk of sovereign default due to fluctuations in exchange rates.

Uncertainty and herd behavior

Main articles: Economic psychology and Herd behavior

Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. Behavioral finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazonhas also analyzed failures of economic reasoning in his concept of 'œcopathy'.

Historians, notably Charles P. Kindleberger, have pointed out that crises often follow soon after major financial or technical innovations that present investors with new types of financial opportunities, which he called "displacements" of investors' expectations. Early examples include the South Sea Bubble and Mississippi Bubble of 1720, which occurred when the notion of investment in shares of company stock was itself new and unfamiliar, and the Crash of 1929, which followed the introduction of new electrical and transportation technologies. More recently, many financial crises followed changes in the investment environment brought about by financial deregulation, and the crash of the dot com bubble in 2001 arguably began with "irrational exuberance" about Internet technology.

Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values. Also, if the first investors in a new class of assets (for example, stock in "dot com" companies) profit from rising asset values as other investors learn about the innovation (in our example, as others learn about the potential of the Internet), then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such "herd behavior" causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices.

Regulatory failures

Main articles: Financial regulation and Bank regulation

Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency: making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, and other limits on leverage.

Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the Managing Director of the IMF, Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'. Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis.

However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital is scarce, potentially aggravating a financial crisis.

Fraud

Main articles: Ponzi scheme and Securities fraud

Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in 2008.

Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated on Sept. 23, 2008 that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group.

Contagion

Main articles: Financial contagion and Systemic risk

Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.

One widely-cited example of contagion was the spread of the Thai crisis in 1997 to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.

Recessionary effects

Some financial crises have little effect outside of the financial sector, like the Wall Street crash of 1987, but other crises are believed to have played a role in decreasing growth in the rest of the economy. There are many theories why a financial crisis could have a recessionary effect on the rest of the economy. These theoretical ideas include the 'financial accelerator', 'flight to quality' and 'flight to liquidity', and the Kiyotaki-Moore model. Some 'third generation' models of currency crises explore how currency crises and banking crises together can cause recessions.

Theories of financial crises

World systems theory

Recurrent major depressions in the world economy at the pace of 20 and 50 years have been the subject of empirical and econometric research especially in the world systems theory and in the debate about Nikolai Kondratiev and the so-called 50-years Kondratiev waves. Major figures of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein, consistently warned about the crash that the world economy is now facing. World systems scholars and Kondratiev cycle researchers always implied that Washington Consensus oriented economists never understood the dangers and perils, which leading industrial nations will be facing and are now facing at the end of the long economic cycle which began after the oil crisis of 1973.

Minsky's theory

Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility.

• for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.
• for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.
• for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principle.

Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed.

Coordination games

Main article: Coordination game

Mathematical approaches to modeling financial crises have emphasized that there is often positive feedback between market participants' decisions (see strategic complementarity). Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals. For example, some models of currency crises (including that of Paul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in an avalanche of currency sales in response to a sufficient deterioration of government finances or underlying economic conditions.

According to some theories, positive feedback implies that the economy can have more than one equilibrium. There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable, but there may be another equilibrium where participants flee asset markets because they expect others to flee too. This is the type of argument underlying Diamond and Dybvig's model of bank runs, in which savers withdraw their assets from the bank because they expect others to withdraw too. Likewise, in Obstfeld's model of currency crises, when economic conditions are neither too bad nor too good, there are two possible outcomes: speculators may or may not decide to attack the currency depending on what they expect other speculators to do.

Herding models and learning models

Main articles: Herd behavior and Adaptive expectations

A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called "strategic complementarity"), but because investors come to believe the true asset value is high when they observe others buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial information about the economy. In these models, when a few investors buy some type of asset, this reveals that they have some positive information about that asset, which increases the rational incentive of others to buy the asset too. Even though this is a fully rational decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a crash) since the first investors may, by chance, have been mistaken.

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be imperfectly rational, basing their reasoning only on recent experience. In such models, if the price of a given asset rises for some period of time, investors may begin to believe that its price always rises, which increases their tendency to buy and thus drives the price up further. Likewise, observing a few price decreases may give rise to a downward price spiral, so in models of this type large fluctuations in asset prices may occur. Agent-based models of financial markets often assume investors act on the basis of adaptive learning or adaptive expectations.

History

A short list of some major financial crises since 20th century

• 1910 – Shanghai rubber stock market crisis
• 1930s – The Great Depression – the largest and most important economic depression in the 20th century
• 1973 – 1973 oil crisis – oil prices soared, causing the 1973–1974 stock market crash
• 1980s – Latin American debt crisis – beginning in Mexico
• 1987 – Black Monday (1987) – the largest one-day percentage decline in stock market history
• 1989-91 – United States Savings & Loan crisis
• 1990s – Japanese asset price bubble collapsed
• 1992-93 – Black Wednesday – speculative attacks on currencies in the European Exchange Rate Mechanism
• 1994-95 – 1994 economic crisis in Mexico – speculative attack and default on Mexican debt
• 1997-98 – 1997 Asian Financial Crisis – devaluations and banking crises across Asia
• 2007-09 – The American financial crisis of 2007–2009 helped create the global financial crisis of 2008–2009, thus creating the late 2000s recession

See also

• Global financial crisis of 2008
• Financial crisis of 2007–2009
• 1998 Russian financial crisis
• Great Depression
• Real estate bubble
• Oil crisis
• Bank run
• Credit crunch
• 2000s energy crisis
• 2007-2008 world food price crisis
• America's Great Depression
• Subprime mortgage crisis
• 1997 Asian Financial Crisis
• Nikolai Kondratiev
• Kondratiev waves
• Overend Gurney crisis - comprised the Panic of 1866 (primarily British)
• Flight-to-Liquidity
• Bailout
• Lender of last resort
• List of recessions in the United States
• Panic of 1819 - pervasive USA economic recession w/ bank failures; culmination of U.S.'s 1st boom-to-bust economic cycle
• Panic of 1825 - pervasive British economic recession in which many British banks failed, & Bank of England nearly failed
• Panic of 1837 - pervasive USA economic recession w/ bank failures; a 5 yr. depression ensued.
• Panic of 1857 - pervasive USA economic recession w/ bank failures
• Panic of 1873 - pervasive USA economic recession w/ bank failures; a 4 yr. depression ensued.
• Panic of 1893 - pervasive USA economic recession w/ bank failures
• Panic of 1901 - limited to crashing of the New York Stock Exchange
• Panic of 1907 - pervasive USA economic recession w/ bank failures

Literature

General perspectives

• Gernot Kohler and Emilio José Chaves (Editors) “Globalization: Critical Perspectives” Haupauge, New York: Nova Science Publishers (http://www.novapublishers.com/) ISBN 1-59033-346-2. With contributions by Samir Amin, Christopher Chase Dunn, Andre Gunder Frank, Immanuel Wallerstein

Most recent aspects

• Lessons from the Asian financial crisis / edited by Richard Carney. New York, NY : Routledge, 2009. ISBN 9780415481908 (hardback) ISBN 0415481902 (hardback) ISBN 9780203884775 (ebook) ISBN 0203884779 (ebook)
• "The myths about the economic crisis, the reformist left and economic democracy" by Takis Fotopoulos, The International Journal of Inclusive Democracy, vol 4, no 4, oct. 2008.

• Funnell, Warwick N. In government we trust : market failure and the delusions of privatisation / Warwick Funnell, Robert Jupe and Jane Andrew. Sydney : University of New South Wales Press, 2009. ISBN 9780868409665 (pbk.)

• Read, Colin, 1959- Global financial meltdown : how we can avoid the next economic crisis / Colin Read. New York : Palgrave Macmillan, c2009. ISBN 9780230222182

• The American housing crisis / Susan Hunnicutt, book editor. Farmington Hills, MI : Greenhaven Press, c2009. ISBN 9780737743104 (hbk.) ISBN 9780737743098 (pbk.)

• United States. Congress. House. Committee on the Judiciary. Subcommittee on Commercial and Administrative Law. Working families in financial crisis : medical debt and bankruptcy : hearing before the Subcommittee on Commercial and Administrative Law of the Committee on the Judiciary, House of Representatives, One Hundred Tenth Congress, first session, July 17, 2007. Washington : U.S. G.P.O. : For sale by the Supt. of Docs., U.S. G.P.O., 2008. 277 p. : ISBN 9780160813764 ISBN 016081376X http://purl.access.gpo.gov/GPO/LPS99198

• Ghilarducci, Teresa. When I'm sixty-four : the plot against pensions and the plan to save them / Teresa Ghilarducci. Princeton : Princeton University Press, c2008. 374 p. ; ISBN 9780691114316 (hbk. : alk. paper)

• Robertson, Justin, 1972- US-Asia economic relations : a political economy of crisis and the rise of new business actors / Justin Robertson. Abingdon, Oxon ; New York, NY : Routledge, 2008. ISBN 9780415469517 (hbk.) ISBN 9780203890523 (ebook)

External links

• NYU Stern on Finance - Blog explaining the Financial Crisis (follow link to research blog run by Stern faculty members which deals with financial economics)
• Crisis Talk - World Bank blog offering information on the unfolding crisis
• Financial Crises: Lessons from History. BBC.
• Rescuing our Jobs and Savings: What G7/8 Leaders Can Do -- policy proposals from leading economists, sponsored by Centre for Economic Policy Research at VOXEU.org.
• Dossier on 2008 financial crisis] by Radio France International's English-language service
• OECD response to the economic crisis. OECD.org.