Financial Crisis: Unraveling the Enigma of Financial Crises, Navigating Economic Turmoil with Wisdom and Insight

By Fouad Sabry

What is Financial Crisis

On the other hand, a financial crisis can refer to any one of a wide range of circumstances in which certain financial assets abruptly lose a significant portion of their nominal value. Over the course of the 19th and early 20th centuries, several financial crises were linked to panics in the banking industry, and numerous recessions occurred concurrently with these panics. In addition to the stock market collapse and the bursting of other financial bubbles, additional occurrences that are sometimes referred to as financial crises include currency crises, sovereign defaults, and stock market crashes. There is a clear correlation between financial crises and a loss of wealth in the form of paper, but these crises do not inevitably result in large changes in the actual economy.

How you will benefit

(I) Insights, and validations about the following topics:

Chapter 1: Financial crisis

Chapter 2: Deflation

Chapter 3: Economic bubble

Chapter 4: Global financial system

Chapter 5: Causes of the Great Depression

Chapter 6: Currency crisis

Chapter 7: Financial contagion

Chapter 8: Economic collapse

Chapter 9: Hyman Minsky

Chapter 10: Poverty

Chapter 11: Subprime mortgage crisis

Chapter 12: Liquidity crisis

Chapter 13: Debt deflation

Chapter 14: Sudden stop (economics)

Chapter 15: Great Recession

Chapter 16: Credit crunch

Chapter 17: Subprime crisis background information

Chapter 18: Extreme poverty

Chapter 19: Causes of the Great Recession

Chapter 20: 2007-2008 financial crisis

Chapter 21: The Return of Depression Economics and the Crisis of 2008

(II) Answering the public top questions about financial crisis.

(III) Real world examples for the usage of financial crisis in many fields.

Who this book is for

Professionals, undergraduate and graduate students, enthusiasts, hobbyists, and those who want to go beyond basic knowledge or information for any kind of financial crisis.

• Language: English
• Publisher: One Billion Knowledgeable
• Release date: Jan 9, 2024

Book preview

Chapter 1: Financial crisis

A financial crisis is any of a wide range of situations in which certain financial assets lose a substantial portion of their nominal value. During the 19th and early 20th centuries, a number of financial crises were associated with banking panics, and a number of recessions occurred concurrently. In addition to stock market crashes and the bursting of other financial bubbles, financial crises also include currency crises and sovereign defaults. Financial crises directly result in a loss of paper wealth, but they do not necessarily cause substantial changes to the real economy (for example, the crisis resulting from the famous tulip mania bubble in the 17th century).

Numerous economists have proposed explanations for how financial crises develop and how they can be avoided. However, there is no consensus, and periodic financial crises continue to occur.

When a bank experiences a sudden influx of withdrawals from depositors, this is known as a bank run. Since banks lend out the majority of the cash they receive in deposits (see fractional-reserve banking), it is difficult for them to quickly repay all deposits if they are suddenly demanded, so a run renders the bank insolvent, causing customers to lose their deposits to the extent that they are not protected by deposit insurance. A widespread bank run is referred to as a systemic banking crisis or banking panic. Generally, banking crises follow periods of risky lending and subsequent loan defaults.

A devaluation crisis, also known as a currency crisis, A speculative bubble exists if a class of assets is vastly and persistently overpriced.

Black Friday, 9 May 1873, Austrian Stock Exchange.

Following the Panic of 1873 was the Long Depression.

Examples of well-known bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania of the 17th century, the South Sea Bubble of the 18th century, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, and the U.S. housing bubble crash of 2006-2008.

A currency crisis or balance of payments crisis occurs when a country with a fixed exchange rate is suddenly forced to devalue its currency due to an unsustainable current account deficit. When a nation defaults on its sovereign debt, this is known as a sovereign default. While devaluation and default could be voluntary decisions of the government, they are frequently viewed as the involuntary results of a change in investor sentiment that causes a sudden halt in capital inflows or a sudden increase in capital flight.

Several currencies that were a part of the European Exchange Rate Mechanism were forced to devalue or withdraw from the mechanism in 1992–1993. Asia experienced another round of currency crises in 1997–98. In the early 1980s, numerous Latin American countries defaulted on their debt. The Russian financial crisis of 1998 led to the devaluation of the ruble and the default of Russian government bonds.

A recession is characterized by two or more quarters of negative GDP growth. A particularly protracted or severe recession is sometimes referred to as a depression, while a lengthy period of slow but not necessarily negative growth is sometimes referred to as economic stagnation.

Declining consumer spending.

Some economists contend that financial crises have contributed significantly to the occurrence of many recessions. The Great Depression is an important example, as it was preceded in many countries by bank runs and stock market crashes. In late 2008 and early 2009, the subprime mortgage crisis and the bursting of other global real estate bubbles caused recession in the United States and a number of other nations. Some economists argue that recessions cause financial crises rather than the other way around, and that even when a financial crisis is the initial shock that triggers a recession, other factors may play a larger role in prolonging it. Particularly, 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 protracted depression if not for the Federal Reserve's monetary policy errors, It is commonly believed that successful investment in a financial market requires each investor to predict what other investors will do. This need to deduce the intentions of others is referred to as reflexivity by George Soros.

Leverage, which refers to the use of debt to finance investments, is frequently cited as a factor in financial crises. When a financial institution (or an individual) only invests its own funds, the worst-case scenario is that it will lose those funds. But when it borrows in order to invest more, it has the potential to earn more, but it also risks losing more than it has. Consequently, leverage magnifies the potential investment returns, but also increases the risk of bankruptcy. Due to the fact that bankruptcy signifies a company's failure to honor all of its promised payments to other companies, it may spread financial difficulties from one company to another (see 'Contagion' below).

Prior to a financial crisis, the average degree of leverage in the economy frequently increases. For instance, borrowing to finance stock market investments (margin buying) became increasingly prevalent prior to the 1929 Wall Street Crash.

A second factor believed to contribute to financial crises is asset-liability mismatch, which occurs when the risks associated with an institution's debts and assets are not aligned appropriately. For instance, commercial banks offer deposit accounts from which withdrawals can be made at any time, and they use the proceeds to make long-term loans to businesses and homeowners. It is believed that the mismatch between banks' short-term liabilities (deposits) and long-term assets (loans) is one of the causes of bank runs (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Similarly, Bear Stearns failed in 2007–2008 due to its inability to renew the short-term debt it had used to finance long-term investments in mortgage securities.

In an international context, many governments of emerging markets are unable to sell bonds denominated in their own currencies and instead sell US dollar-denominated bonds. This creates a mismatch between the currency denominations of their liabilities (bonds) and assets (local tax revenues), putting them at risk of sovereign default due to fluctuations in exchange rates.

Numerous analyses of financial crises emphasize the role of investment errors brought on by ignorance or the fallacies of human reasoning.

Errors in economic and quantitative logic are prevalent in behavioural finance studies.

Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'.

Investors' tendency to grossly overestimate asset values may be partially explained by their unfamiliarity with recent technical and financial innovations. In addition, if the first investors in a new class of assets (for instance, stock in dot-com companies) profit from rising asset values as other investors learn about the innovation (in our example, as other investors learn about the potential of the Internet), then more investors may follow their lead, driving the price even higher as they rush to buy in hopes of achieving similar profits. If such herd behavior causes prices to skyrocket far beyond the assets' true value, a market crash may be inevitable. If, for some reason, the price falls momentarily, causing investors to realize that further gains are not guaranteed, the downward spiral may reverse, with price decreases causing a rush of sales and reinforcing the price decline.

By regulating the financial sector, governments have attempted to eliminate or reduce financial crises. Transparency is a major objective of regulation, which seeks to make institutions' financial situations public by mandating regular reporting using standardized accounting procedures. Through reserve requirements, capital requirements, and other limits on leverage, a second objective of regulation is to ensure that institutions have sufficient assets to meet their contractual obligations.

Some financial crises have been attributed to inadequate regulation, prompting regulatory changes to prevent a recurrence. For instance, the former managing director of the International Monetary Fund, Dominique Strauss-Kahn, attributed the 2007–2008 financial crisis to regulatory failure to prevent excessive risk-taking in the financial system, particularly in the United States. Maintaining diverse regulatory regimes would be a safeguard from this perspective.

When companies enticed depositors with deceptive claims about their investment strategies or embezzled the resulting income, fraud played a role in the collapse of certain financial institutions. Examples include Charles Ponzi's fraud in early 20th-century Boston, the collapse of the MMM investment fund in Russia in 1994, the frauds that precipitated the Albanian Lottery Uprising in 1997, and the collapse of Madoff Investment Securities in 2008.

Many unscrupulous traders who have caused significant losses at financial institutions have been accused of committing fraud to conceal their trades. Fraud in mortgage financing has also been cited as a possible cause of the 2008 subprime mortgage crisis; on 23 September 2008, government officials stated that the FBI was investigating possible fraud by Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group.

Contagion refers to the notion that financial crises can spread from one institution to another, such as when a bank run spreads from a few banks to many others, or from one country to another, such as when currency crises, sovereign defaults, or stock market crashes spread internationally. Systemic risk is when the failure of a single financial institution threatens the stability of numerous other institutions.

The 1997 spread of the Thai crisis to other nations, including South Korea, is a frequently cited example of contagion. However, economists frequently debate whether the simultaneous occurrence of crises in a number of countries is truly attributable to market contagion or to similar underlying problems that would have affected each country individually even in the absence of international ties.

Crises, according to the Banking School theory of the nineteenth century, were caused by flows of investment capital between regions with different interest rates. Capital could be borrowed in low-interest regions and invested in high-interest regions. Using this method, it is possible to generate a small profit with little or no capital. However, when interest rates changed and the incentive for the flow was eliminated or reversed, capital flows could undergo abrupt changes. The subjects of investment may be deprived of cash, leading to possible insolvency and a credit crunch, and the loaning banks would be left with defaulting investors, resulting in a banking crisis.

Some financial crises, such as the 1987 Wall Street crash, have little effect outside of the financial sector, whereas other crises are believed to have contributed to slower economic growth in other sectors. There are numerous hypotheses as to why a financial crisis might cause a recession in the rest of the economy. These theories include the 'financial accelerator,' 'flight to quality,' and 'flight to liquidity,' as well as the Kiyotaki-Moore model. Some 'third generation' models of currency crises investigate the relationship between currency crises and banking crises as a cause of recessions.

Ludwig von Mises and Friedrich Hayek of the Austrian School discussed the business cycle beginning 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 since Jean 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.

Karl Marx's mature works were dominated by the idea of developing a theory of economic crisis.

Marx's law of the tendency for the rate of profit to fall was heavily influenced by John Stuart Mill's Of the Tendency of Profits to a Minimum (Principles of Political Economy Book IV Chapter IV).

The theory is a corollary of the tendency toward profit centralization.

In a capitalist system, successful businesses return (in the form of wages) less money to their workers than the value of the goods produced by those workers (i.e. the amount of money the products are sold for). This profit is first applied to covering the business's initial investment. In the long run, however, when one considers the combined economic activity of all successful businesses, it is evident that less money (in the form of wages) is returned to the majority of the population (the workers) than is available for them to purchase all of the goods being produced. Moreover, the expansion of businesses as a result of market competition results in an abundance of goods and a general decline in their prices, which exacerbates the tendency for the profit rate to decline.

The viability of this theory depends on two major factors: first, the extent to which government taxes profits and returns them to the masses in the form of welfare, family benefits, and health and education spending; and second, the percentage of the population that consists of workers as opposed to investors/business owners. Given the extraordinary capital expenditure required to enter contemporary economic sectors such as airline transport, the military industry, and chemical production, these sectors are exceedingly difficult for new businesses to enter and are becoming increasingly concentrated.

Empirical and econometric research continues, particularly in the world systems theory and the debate surrounding Nikolai Kondratiev and the so-called Kondratiev waves that span 50 years. Major figures of world systems theory, such as Andre Gunder Frank and Immanuel Wallerstein, have repeatedly warned of the impending global economic collapse. World systems scholars and Kondratiev cycle researchers have always implied that Washington Consensus-oriented economists never understood the dangers and perils that leading industrial nations face and will face at the end of the long economic cycle that began with the 1973 oil crisis.

The post-Keynesian explanation proposed by Hyman Minsky is most applicable to closed economies. He hypothesized that financial instability is a characteristic of all capitalist economies. A high degree of fragility increases the likelihood of a financial crisis. To facilitate his analysis, Minsky identifies three financing strategies firms may choose from, based on their risk tolerance. There are three types of finance: hedge finance, speculative finance, and Ponzi finance. Ponzi finance causes the greatest instability.

In hedge finance, income flows are expected to cover all financial obligations, including loan principal and interest, in every period.

For speculative finance, a company must roll over debt because it is anticipated that income flows will only cover interest costs. None of the principal has been repaid.

For Ponzi finance, expected cash flows won't even cover interest expenses, so the company must borrow additional funds or liquidate assets just to service its debt. The expectation is that either the market value of the assets or the income will increase sufficiently to cover interest and principal.

The degree of financial fragility fluctuates in tandem with the business cycle. After a recession, firms have lost a substantial amount of capital and choose only hedge, the safest investment option. As the economy expands and expected profits rise, businesses believe they can afford to engage in speculative financing. In this case, they are aware that profits will not always cover interest expenses. However, businesses believe that profits will increase and loans will be repaid without difficulty. More loans result in increased investment, and the economy expands. Then lenders begin to believe that they will receive all of the money they lend back. Therefore, they are willing to lend to businesses without complete success