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8.3 Modern History of Financial Crises

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe recurrent themes of financial crises.
  2. Enumerate recent financial crises.
  3. Describe how financial crises can relate to the business cycle.

Financial crises are not new phenomena, existing at least since coins have been used for currency; very early crises tended to focus on the debasement of hard currency (that is, whether the metal in the coins had the value the coin declared) or on a government’s solvencyThe ability of an entity to successfully repay debt., or ability to successfully repay debt (and, thus, were often tied to political crises). Most modern crises are similar in that they involve an uncetainty in the valuation of some sort of asset, and many also include a decline in confidence of governments or banks and other financial institutions.

The most significant financial crisis of the 20th century was the Great Depression, which is typically dated as lasting from the stock market crash in 1929 through the next decade into the beginning of World War II. During the depression, many banks failed, particularly when investors would have doubts about a banks solvency, choosing to withdraw all deposited funds in a run on the bankWhen investors have doubts about a banks solvency, choosing to withdraw all deposited funds..

The last thirty years in the United States have witnessed the stock market crash of 1987, the savings and loan crisis, the liquidation of Long Term Capital Management in 1998, the bursting of the internet bubble in 2000–2001, and the housing bubble/financial crisis. Other countries have had their fair share of crises as well (for example, the Asian currency crisis), though as the economy has become more global in nature, as have the crises. For example, the latest crisis (by some metrics, the worst since the Great Depression) has had serious implications on the stability of the European Union and questions of solvency regarding Greece, Ireland, Portugal, Spain, among other nations.

Financial crises are often tied with the concept of the business cycleThe periodic rise and fall of nations’ gross domestic product observed over years., the periodic rise and fall of nations’ gross domestic product observed over years. The direction of causality is a hotly debated topic (that is, whether financial crises tend to be caused by or are the cause of a lagging economy). Asset bubblesA type of asset (like real estate, technology stocks, or tulips) rises dramatically in valuation seemingly well beyond its intrinsic value., where a type of asset (like real estate, technology stocks, or tulips) rises dramatically in valuation seemingly well beyond its intrinsic value, are often a component in these boom/bust patterns; the dramatic increase in the asset’s value leading up to the “bubble bursting” makes the decline in value have a larger impact on the balance sheet of the asset owners. Despite having a seemingly regular periodic occurrence, the effective predictability of the specific cause a financial crisis is also a debated topic.See the work of Nassim Nicholas Taleb regarding “black swans”.

Key Takeaways

  • Financial crises usually boil down to issues of trust: either trust in the value of an asset, or of an entity like a government or bank.
  • Financial crises often correlate with the down-swing of a business cycle, though it isn’t always clear which caused the other.

Exercise

  1. What are some factors that have contributed to past financial crises?