Afinancial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated withbanking panics, and manyrecessions coincided with these panics. Other situations that are often called financial crises includestock market crashes and the bursting of other financialbubbles,currency crises, andsovereign defaults.[1][2] Financial crises directly result in a loss ofpaper wealth but do not necessarily result in significant changes in the real economy (for example, the crisis resulting from the famoustulip mania bubble in the 17th century).
Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus and financial crises continue to occur from time to time. It is apparent however that a consistent feature of both economic (and other applied finance disciplines) is the obvious inability to predict and avert financial crises.[3] This realization raises the question as to what is known and also capable of being known (i.e. theepistemology) within economics and applied finance. It has been argued that the assumptions of unique, well-defined causal chains being present in economic thinking, models and data, could, in part, explain why financial crises are often inherent and unavoidable.[4]
When a bank suffers a sudden rush of withdrawals by depositors, this is called abank run. Since banks lend out most of the cash they receive in deposits (seefractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. An event in which bank runs are widespread is called asystemic banking crisis orbanking panic.[5]
A currency crisis, also called a devaluation crisis,[7] is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as occurring when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of a currency of at least 25% but it is also defined as at least a 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that apegged exchange rate is about to fail, causingspeculation against the peg that hastens the failure and forces adevaluation.[7]
A speculative bubble (also called a financial bubble or an economic bubble) exists in the event of large, sustained overpricing of some class of assets.[8] One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is also a risk of acrash 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 predict 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.[9]
When a country that maintains afixed exchange rate is suddenly forced todevalue its currency due to accruing an unsustainable current account deficit, this is called acurrency crisis orbalance of payments crisis. When a country fails to pay back itssovereign debt, this is called asovereign 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 asudden stop in capital inflows or a sudden increase incapital flight.
Negative GDP growth lasting two or more quarters is called arecession. An especially prolonged or severe recession may be called adepression, while a long period of slow but not necessarily negative growth is sometimes calledeconomic stagnation.
Declining consumer spending
Some economists argue that many recessions have been caused in large part by financial crises. One important example is theGreat Depression, which was preceded in many countries by bank runs and stock market crashes. Thesubprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009.Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where 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 andAnna Schwartzargued that the initial economic decline associated with thecrash 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,[13] a position supported byBen Bernanke.[14]
It is often observed that successful investment requires each investor in a financial market to guess what other investors will do.Reflexivity refers to the circular relationships often evident in social systems between cause and effect – and relates to the property of self-referencing in financial markets.[15]George Soros has been a proponent of thereflexivity paradigm surrounding financial crises.[16] Similarly,John Maynard Keynes compared financial markets to abeauty contest game in which each participant tries to predict which modelother participants will consider most beautiful.[17]
Furthermore, in many cases, investors have incentives tocoordinate their choices. For example, someone who thinks other investors want to heavily buyJapanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen, too. Likewise, a depositor inIndyMac 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 othersstrategic complementarity.[18]
It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, thenself-fulfilling prophecies may occur.[19] 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.[20] Therefore, financial crises are sometimes viewed as avicious circle in which investors shun some institution or asset because they expect others to do so.[21] Reflexivity poses a challenge to the epistemic norms typically assumed within financial economics and all of empirical finance.[4] The possibility of financial crises being beyond the predictive reach of causality is discussed further withinEpistemology of 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 ofbankruptcy. 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).
Another factor believed to contribute to financial crises isasset-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 that 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 reasonsbank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans).[20] Likewise,Bear Stearns failed in 2007–08 because it was unable to renew theshort-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 ofsovereign default due to fluctuations in exchange rates.[22]
Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning.Behavioural finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'.[23]
Historians, notablyCharles 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.[24][25] Early examples include theSouth Sea Bubble andMississippi Bubble of 1720, which occurred when the notion of investment in shares of companystock was itself new and unfamiliar,[26] and theCrash of 1929, which followed the introduction of new electrical and transportation technologies.[27] More recently, many financial crises followed changes in the investment environment brought about by financialderegulation, and the crash of thedot com bubble in 2001 arguably began with "irrational exuberance" about Internet technology.[28]
Unfamiliarity with recent technical andfinancial 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 behaviour" 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.
Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation istransparency: 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, throughreserve requirements,capital requirements, and other limits onleverage.
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 former managing director of theInternational Monetary Fund,Dominique Strauss-Kahn, has blamed the2008 financial crisis on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'.[29] Likewise,The New York Times singled out the deregulation ofcredit default swaps as a cause of the crisis.[30]
However, excessive regulation has also been cited as a possible cause of financial crises. In particular, theBasel 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.[31]
International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding (discussed above) and so increasing systemic risk.[32][33] From this perspective, maintaining diverse regulatory regimes would be a safeguard.
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 haveembezzled the resulting income. Examples includeCharles Ponzi's scam in early 20th century Boston, the collapse of theMMM investment fund in Russia in 1994, the scams that led to theAlbanian Lottery Uprising of 1997, and the collapse ofMadoff Investment Securities in 2008.
Manyrogue 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 2008subprime mortgage crisis; government officials stated on 23 September 2008 that theFBI was looking into possible fraud by mortgage financing companiesFannie Mae andFreddie Mac,Lehman Brothers, and insurerAmerican International Group.[34] Likewise it has been argued that many financial companies failed in therecent crisis[clarification needed] because their managers failed to carry out their fiduciary duties.[35]
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 calledsystemic risk.[32]
One widely cited example of contagion was the spread of theThai crisis in 1997 to other countries likeSouth 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.
The nineteenth century Banking School theory of crises suggested that crises were caused by flows of investment capital between areas with different rates of interest. Capital could be borrowed in areas with low interest rates and invested in areas of high interest. Using this method a small profit could be made with little or no capital. However, when interest rates changed and the incentive for the flow was removed or reversed sudden changes in capital flows could occur. The subjects of investment might be starved of cash possibly becoming insolvent and creating acredit crunch and the loaning banks would be left with defaulting investors leading to a banking crisis.[36] As Charles Read has pointed out, the modern equivalent of this process involves theCarry Trade, see Carry (investment).[37]
Austrian School economists Ludwig von Mises and Friedrich Hayek discussed the business cycle starting with Mises'Theory of Money and Credit, published in 1912.
Recurrent major depressions in the world economy at the pace of 20 and 50 years have been the subject of studies sinceJean Charles Léonard de Sismondi (1773–1842) provided the first theory of crisis in a critique of classical political economy's assumption of equilibrium between supply and demand. Developing an economiccrisis theory became the central recurring concept throughoutKarl Marx's mature work. Marx'slaw of the tendency for the rate of profit to fall borrowed many features of the presentation ofJohn Stuart Mill's discussionOf the Tendency of Profits to a Minimum (Principles of Political Economy Book IV Chapter IV). The theory is a corollary of theTendency towards the Centralization of Profits.
In a capitalist system, successfully-operating businesses return less money to their workers (in the form of wages) than the value of the goods produced by those workers (i.e. the amount of money the products are sold for). Thisprofit first goes towards covering the initial investment in the business. In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money (in the form of wages) is being returned to the mass of the population (the workers) than is available to them to buy all of these goods being produced. Furthermore, the expansion of businesses in the process of competing for markets leads to an abundance of goods and a general fall in their prices, further exacerbatingthe tendency for the rate of profit to fall.
The viability of this theory depends upon two main factors: firstly, the degree to which profit is taxed by government and returned to the mass of people in the form of welfare, family benefits and health and education spending; and secondly, the proportion of the population who are workers rather than investors/business owners. Given the extraordinary capital expenditure required to enter modern economic sectors like airline transport, the military industry, or chemical production, these sectors are extremely difficult for new businesses to enter and are being concentrated in fewer and fewer hands.
Empirical and econometric research continues especially in theworld systems theory and in the debate aboutNikolai Kondratiev and the so-called 50-yearsKondratiev waves. Major figures of world systems theory, likeAndre Gunder Frank andImmanuel Wallerstein, consistently warned about the crash that the world economy is now facing.[citation needed] World systems scholars and Kondratiev cycle researchers always implied thatWashington 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 longeconomic cycle which began after theoil crisis of 1973.
Hyman Minsky has proposed apost-Keynesian explanation that is most applicable to a closed economy. He theorized thatfinancial fragility is a typical feature of anycapitalisteconomy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches that financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, andPonzi 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 principal.
Financial fragility levels move together with thebusiness cycle. After arecession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expectedprofits 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 theinterest 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.
Starting at a time when short-term interest rates are low, frustration builds up among investors who search for a better yield in countries and locations with higher rates, leading to increased capital flows to countries with higher rates. Internally, short-term rates rise above long-term rates causing failures where borrowing at short term rates has been used to invest long-term where the funds cannot be liquidated quickly (a similar mechanism was implicated in the March 2023 failure ofSVB Bank). Internationally, arbitrage and the need to stop capital flows, which caused bullion drains in the gold standard of the nineteenth century and drains of foreign capital later, bring interest rates in the low-rate country up to equal those in the country which is the subject of investment.
The capital flows reverse or cease suddenly causing the subject of investment to be starved of funds and the remaining investors (often those who are least knowledgeable) to be left with devalued assets. Bankruptcies, defaults and bank failures follow as rates are pushed high. After the crisis governments push short-term interest rates low again to diminish the cost of servicing government borrowing which has been used to overcome the crisis. Funds build up again looking for investment opportunities and the cycle restarts from the beginning.[39]
Mathematical approaches to modeling financial crises have emphasized that there is oftenpositive feedback[40] between market participants' decisions (seestrategic complementarity).[41] 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 ofPaul Krugman) imply that a fixed exchange rate may be stable for a long period of time, but will collapse suddenly in anavalanche of currency sales in response to a sufficient deterioration of government finances or underlying economic conditions.[42][43]
According to some theories, positive feedback implies that the economy can have more than oneequilibrium. There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable. This is the type of argument underlyingDiamond and Dybvig's model ofbank runs, in which savers withdraw their assets from the bank because they expect others to withdraw too.[20] Likewise, inObstfeld'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.[21]
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.[44][45][46][47] Herding models, based onComplexity Science, indicate that it is the internal structure of the market, not external influences, which is primarily responsible for crashes.[48]
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.
A noted survey of financial crises isThis Time is Different: Eight Centuries of Financial Folly (Reinhart & Rogoff 2009), by economistsCarmen Reinhart andKenneth Rogoff, who are regarded as among the foremost historians of financial crises.[49] In this survey, they trace the history of financial crisis back tosovereign defaults – default onpublic debt, – which were the form of crisis prior to the 18th century and continue, then and now causing private bank failures; crises since the 18th century feature both public debt default and private debt default. Reinhart and Rogoff also classdebasement of currency andhyperinflation as being forms of financial crisis, broadly speaking, because they lead to unilateral reduction (repudiation) of debt.
Reinhart and Rogoff trace inflation (to reduce debt) toDionysius I's rule inSyracuse and begin their "eight centuries" in 1258; debasement of currency also occurred under theRoman Empire andByzantine Empire. TheFinancial crisis of 33 caused by a contraction of money supply had been recorded by several Roman historians.[50]
Among the earliest crises Reinhart and Rogoff studied is the 1340 default of England, due to setbacks in its war with France (theHundred Years' War; seedetails). Further early sovereign defaults include seven defaults by theSpanish Empire, four underPhilip II, three under his successors.
Other global and national financial mania since the 17th century include:
1637: Bursting oftulip mania in the Netherlands – while tulip mania is popularly reported as an example of a financial crisis, and was a speculative bubble,modern scholarship holds that its broader economic impact was limited to negligible, and that it did not precipitate a financial crisis.
1720: Bursting ofSouth Sea Bubble (Great Britain) andMississippi Bubble (France) – earliest of modern financial crises; in both cases the company assumed the national debt of the country (80–85% in Great Britain, 100% in France), and thereupon the bubble burst. The resulting crisis of confidence probably had a deep impact on the financial and political development of France.[51]
Crisis of 1772 – in London and Amsterdam. 20 important banks in London went bankrupt after one banking house defaulted (bankers Neal, James, Fordyce and Down).
France's Financial and Debt Crisis (1783–1788) – France severe financial crisis due to the immense debt accrued through the French involvement in the Seven Years' War (1756–1763) and the American Revolution (1775–1783).
Panic of 1792 – run on banks in US precipitated by the expansion of credit by the newly formed Bank of the United States.
Panic of 1796–1797 – British and US credit crisis caused by land speculation bubble.
Panic of 1857: pervasive USA economic recession with bank failures. The world economy was also moreinterconnected by the 1850s, which also made the Panic of 1857 the first worldwide economic crisis.[52]
Panic of 1873: pervasive USA economic recession with bank failures, known then as the 5 yearGreat Depression and now as theLong Depression.
Panic of 1884: a panic in the United States centred on New York banks.
Panic of 1890: aka Baring Crisis; near-failure of a major London bank led to corresponding South American financial crises.
Panic of 1893: a panic in the United States marked by the collapse of railroad overbuilding and shaky railroad financing which set off a series of bank failures.
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