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12.1 Financial Crises

Learning Objective

  1. What is a financial crisis?

A financial crisisThe functioning of one or more financial markets or intermediaries becomes erratic or ceases altogether. occurs when one or more financial markets or intermediaries cease functioning or function only erratically and inefficiently. A nonsystemic crisisA particular market or intermediary functions erratically or inefficiently. involves only one or a few markets or sectors, like the Savings and Loan Crisis described in Chapter 11 "The Economics of Financial Regulation". A systemic crisisThe functioning of all, or nearly all, of the financial system degrades. involves all, or almost all, of the financial system to some extent, as during the Great Depression.

Financial crises are neither new nor unusual. Thousands of crises, including the infamous Tulip Mania and South Sea Company episodes, have rocked financial systems throughout the world in the past five hundred years. Two such crises, in 1764–1768 and 1773, helped lead to the American Revolution.Tim Arango, “The Housing-Bubble and the American Revolution,” New York Times (29 November 2008), WK5. After its independence, the United States suffered systemic crises in 1792, 1818–1819, 1837–1839, 1857, 1873, 1884, 1893–1895, 1907, 1929–1933, and 2008. Nonsystemic crises have been even more numerous and include the credit crunch of 1966, stock market crashes in 1973–1974 (when the Dow dropped from a 1,039 close on January 12, 1973, to a 788 close on December 5, 1973, to a 578 close on December 6, 1974) and 1987, the failure of Long-Term Capital Management in 1998, the dot-com troubles of 2000, the dramatic events following the terrorist attacks in 2001, and the subprime mortgage debacle of 2007. Sometimes, nonsystemic crises burn out or are brought under control before they spread to other parts of the financial system. Other times, as in 1929 and 2007, nonsystemic crises spread like a wildfire until they threaten to burn the entire system.

Stop and Think Box

“While we ridicule ancient superstition we have an implicit faith in the bubbles of banking, and yet it is difficult to discover a greater absurdity, in ascribing omnipotence to bulls, cats and onions, than for a man to carry about a thousand acres of land . . . in his pocket book. . . . This gross bubble is practiced every day, even upon the infidelity of avarice itself. . . . So we see wise and honest Americans, of the nineteenth century, embracing phantoms for realities, and running mad in schemes of refinement, tastes, pleasures, wealth and power, by the soul [sic] aid of this hocus pocus.”—Cause of, and Cure for, Hard Times. When were these words penned? How do you know?

This was undoubtedly penned during one of the nineteenth century U.S. financial crises mentioned above. Note the negative tone, the allusion to Americans, and the reference to the nineteenth century. In fact, the pamphlet appeared in 1818. For a kick, compare/contrast it to blogs bemoaning the crisis that began in 2007:

Both systemic and nonsystemic crises damage the real economy by preventing the normal flow of credit from savers to entrepreneurs and other businesses and by making it more difficult or expensive to spread risks. Given the damage financial crises can cause, scholars and policymakers are keenly interested in their causes and consequences. You should be, too.

Key Takeaways

  • Throughout history, systemic (widespread) and nonsystemic (confined to a few industries) financial crises have damaged the real economy by disrupting the normal flow of credit and insurance.
  • Understanding the causes and consequences of financial crises is therefore important.