Financial & Economic Crisis

The Theory of Financial Crises


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

When a commercial 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, 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 runs 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 is also sometimes 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 1990-1991.

Speculative bubbles and crashes

Economists say that a financial asset such as stock, for example, exhibits a bubble when its price exceeds the 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 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 1997-1998. 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 debt.

Wider economic crises

A downturn in economic growth lasting several quarters or more is usually 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 sub-prime 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 effects of financial crises

Strategic complementarities in financial markets

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.

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.


Leverage means borrowing to finance investments and is frequently cited as a contributor to financial crises. When a financial institution or an individual invest their own money, they can, in the worst case scenario, lose their own money. However, when they borrow in order to invest more, they can potentially earn more from their investment, but can also lose more than everything they own. Therefore leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honour all its promised payments to other firms, it may spread financial troubles from one firm to another.
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 called "margin buying" became increasingly common prior to the Wall Street Crash of 1929.

Regulatory failures

Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency: making institutions' financial situation 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 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, and the scams that led to the Albanian Lottery Uprising of 1997.
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 sub-prime 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 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.

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-year Kondratiev waves. Major figures in world systems theory such as 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.

Coordination games

Mathematical approaches to modelling financial crises have emphasized that there is often positive feedback between market participants' decisions. 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 a number of equilibriums. 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.

Minsky's theory

Hyman Minsky has proposed a simplified 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 types of financing firms chosen according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility. 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 credit risk. 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.


This article uses material from the Wikipedia article "Financial Crisis"


<< Global Financial Crisis main page