A historical overview of Financial Crises

We cannot dispute the fact that markets have come a long way in terms of expertise. Today, there is so much knowledge in the world that getting anything you want is incredibly easy. There is more information, too, with the emergence of internet technology and living in the information era. The digital realm makes things real and up-to-date. There has been a crazy trend of improved technologies and services delivered over the past few decades. Economic experts have been at the forefront of identifying new avenues and loopholes that could stabilize or bring down markets.

Despite these new ways of doing things, it is hard quite amazing how the market keeps repeating history as irrational exuberance comes before and similarly irrational state of despair. As a result, the world has often been caught beneath inevitable results. As much as we try to avoid them, there always comes a time when consumers and producers go through hard times because of economic difficulty. Economic fluctuations due to the imperfect nature of markets are among the main cause of these situations. Sometimes those caught in the chaos seem to wonder why they never noticed it in the first place, whereas the truth is there is nothing anyone can about it. Business cycles are a natural phenomenon that keeps markets in check. Hence, they are part of modern markets and will continue existing so.

Financial markets and crises

Financial markets are among the most important markets in the general economic world. They are, mostly, the main determinants of economic processes and progress. Since they determine the flow of cash, most businesses rely on their stability for growth. If a company wants to invest in a foreign country, they look at the monetary policies that guide their financial sector operations. If they must borrow a loan, for instance, they have to consider the interest rates, the current economic situation, and the term of the loan. For instance, in the developing world, financial institutions offer flexible loans to small and medium scale businesses. All these only shows just how important these markets to an economy.

However, financial markets crises have been part and parcel of the industry since its foundation. For this reason, bankers and financiers have come to terms with the fact that such a large business arena, which is global and complex at best, stating that these events can be avoided is just being naïve. Consider just how many crises have happened in the market for the past four or so decades. They all suggest a high degree of commonality. Nobody can escape the excessive exuberance, poor regulatory oversite, tricky accounting, hard mentality, and even a sense of infallibility.

Richard Rhodes writes in his book, "Banker to the World," countries and markets have a common theme of wanting to believe they are different. They think they are not connected to the rest of the world's economy. Rhodes notes that the 1982 debt crisis has recurred several times, having lived through almost every major crises. It is the same thing happening in Europe and the rest of the world.

Students majoring in economic studies must understand these crises as part of topics in microeconomics. When they happen, both firms and households feel the same impact. And because they will keep happening, despite all the predictions, analysis, and measures to curb them, there will always situations where they recur. Understanding how they occur and why they do can lead to a higher level of preparedness. It may not stop, but it can help in the recovery process. After all, policymakers create fiscal and monetary policies based on prior data.

What is a Financial Crisis?

Despite seemly obvious, defining a financial crisis can be broader than you expect. It can be defined as any wide variety of conditions where some financial assets a huge part of their nominal value abruptly. It is important to note that these assets suddenly lose their value without anyone expecting them to. For instance, a rise in houses' value can incite financiers to give loans without following proper protocol. If these assets' value falls, it becomes very hard for the firms to recover their money, which leads to some falling and another settling on the verge of collapse,

In the 19th century and the beginning of the 20th century, many of these crises were linked to banking panics. Consumers did not feel comfortable leaving their money in banks; maybe because of constant thefts, they rushed to withdraw in masses. And when recessions coincided with these panics, the results were catastrophic. Among other situations that cause financial crises are stock market crashes as well as bursting of financial bubbles. Currency crises and sovereign defaults even now cause crises. When a financial crisis occurs, it led to the loss of paper wealth, but it might not cause significant changes to the real Economy.

Many economic analysts have come up with theories and models on the development of financial crises and the possible ways to avoid them. Nonetheless, there is no consensus, and financial crises continue to rage.

Types of financial crises

There are several types of financial crises, and each of them has a different effect on the real economy.

Banking crisis

Sometimes, banks may suffer a sudden rush of withdrawals – called a bank run – which could lead to a crisis. But banks lend out most of the deposits received, which makes it hard to pay the suddenly demanded cash. The bank is rendered insolvent, which leads to loss of deposits by customers, some much that the deposit insurance does not cover them. If a bank runs, it becomes a systematic banking crisis. The run of the Bank of the United States in 1931 and the run of the Northern Rock of 2007 are the basic examples of banking crises. These periods normally accompany a period of risky lending.

Currency crisis

Also known as the devaluation crisis, a currency crisis is seen as part of a financial crisis. It occurs "when a weighted average of monthly percentage depreciation in the exchange rate and monthly percentage declines in exchange reverses exceeds it mean by more than three standard deviations." Kamisky et al. (1998). Frankel and Rose (1996) define this situation as the nominal decline in the current value by at least 25% or a least 10% in the rate of depreciation.

Speculative bubble and cruses

Sometimes there could be a large, sustained overpricing of some class asset, which leads to a speculative bubble. One of the main factors causing this situation is buyers who purchase an asset hoping they can resell later at a higher price. If there are too many buyers of the asset (a bubble), it creates a risk of a crash in the asset price. As long as others are buying, market participants will buy, which could result in reduced prices when they want to sell.

The Dutch tulip mania of the 17th century, the South Sea Bubble of the 18th century, Wall Street Crush in 1929, and the non-deflating United States housing bubbles are examples of such crises.

Biggest financial crises in History

1929 – 1939: The Great Depression

There was never a fiercer financial and economic disaster in the 20th century that this Great Depression. According to make analysis, it was triggered by the Wall Street crash of 1929. And then the poor policy decision by the US government made it even worse. For more than ten years, the crisis lit throughout the country, causing a massive loss of income and a high unemployment rate. These effects were felt across the globe.

1973 – The OPEC Oil Price Shock

When the Organization of the Petroleum Exporting Countries (OPEC) member nations (mostly Arab) made the decision to retaliate against the US after its send arms supplies to Israel at the peak of the fourth Arab-Israeli War, it triggered the beginning of the oil price shock. The nations abruptly halted oil supply to the US and its allies, a situation that caused a huge oil shortage. Oil prices went through the roof, leading to an economic crisis in the US. There as a simultaneous occurrence of very high inflation and economic stagnation.

1997 – the Asian crisis

This crisis begun in Thailand in 1997 and quickly affected the rest of East Asia and neighboring countries. There was a speculative capital flow developed economies to East Asia, nations like Thailand, Indonesia, Malaysia, Hong Kong, South Korea, and Singapore that gave rise to a state of optimism. There was an overextension of credit and abnormal debt accumulation in the economies. Thai had left their fixed exchange rate with the US dollar that had been there for long. This initiated a wave of panic across Asia that led to a reversal of billions of dollars from foreign investors. Market and investors were concerned about these economies' possible bankruptcy, leading to a long-lasting economic crisis.

1982 – LatAm sovereign debt crisis

This crisis becomes apparent when Latin Americans who had taken advantage of the cheap foreign debt realized they could not repay the loans accumulated for a long time. The main participants, Mexico, Brazil, and Argentina, had been borrowing money for development programs. As usual, the economies were doing well with the right infrastructure initiatives underway, and everyone was enjoying it when it was happening. It was a time when no one could agree that anything could go wrong. The banks were generous with their lending terms and gave out money quickly to a point where the region's debt increased three folds. In the 1970s, the world economy faced a recession that led to more issues in this debt. Interest rates on bonds went high, as the currencies in the Latin-American region plummeted. The crises started officially in 1982 with the Mexican PM Jesus Silva-Herzog stated that the country could not repay their debt.

This crisis took a very long time before a solution was found. Region resorted to a bailout's IMF assistance, promising to give in with pro-market reforms and austerity programs. As if that was not enough, the 1989 novel creation of Brady bonds were initiated a measure to reduce debt in the affected countries. This process included converting distressed sovereign debt into a small number of various bond types. More initiatives were implemented, with banks exchanging claims on the debts for tradable assets. As such, the debt was taken off the balance sheets.

It was recorded by may as a very tense moment, but a strong political leadership steered the affected nation safely through the crisis. However, many nations seem to have failed to learn from these occurrences. We have seen how the Asian or eurozone crisis has occurred because the governments did not learn the right lessons from their affected nations.

The 1980s – Savings and Loans crisis

Financial markets play a very critical role in economic development. When there are changes in this sector, the real Economy is often affected too. While the Latin American crises were under the reconciliation process, the US regulators faced other issues. They called it the savings and loan crisis the extended throughout the 80s, and its impact was felt even in the early 90s. Over 700 savings and loan association fell into a ditch. The institutions lent long term fixed rates by using short-term money. The interest rate began rising at a time when many become insolvent. Luckily, a strong political environment was there already to ensure what was happening could be handled easily to avoid further issues in the Economy.

The government was fast to respond by issuing a set of regulations known as the Financial Institution Reform, Recovery, and Enforcement Act of 1989. The policy was set to tighten rules on S & L, but it also gave more responsibilities to Freddy Mac and Fannie Mae, who were now expected to support mortgages for lower-income people.

Those who lived through the crises have a lot to tell because it affected many investments. Even though it did not touch a large part of the real economy, it was still big enough to shake it. And chances are it was one of the reasons for the 2008 crisis.

2008 -2009 – Financial Crisis

This crisis led to eh Great Recession as one of the harshest crises in the 21st century. It wreaked havoc in financial markets across the globe, leading to the collapse of large corporations like Lehman Brothers.

Author: James Hamilton