3.4 Global financial crises and contagion

Global financial crises can wreak havoc on economies worldwide. They're often caused by asset bubbles, excessive risk-taking, and regulatory failures. When one country's economy tanks, it can spread like wildfire to others through interconnected financial systems and panicked investors.

Governments and central banks respond with tools like interest rate cuts, stimulus packages, and bailouts. But the effects can linger for years, leading to slow growth and high unemployment. These crises also spark major changes in financial regulations and the global economic order.

Causes of Global Financial Crises

Asset Bubbles and Market Vulnerabilities

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• Asset bubbles occur when prices of assets (real estate, stocks) become detached from their fundamental value
  • Housing bubble in the United States prior to the 2008 financial crisis
  • Dot-com bubble in the late 1990s
• Excessive leverage and risk-taking by financial institutions amplify vulnerabilities in the financial system
  • High leverage ratios in investment banks before the 2008 crisis
  • Use of complex financial instruments (collateralized debt obligations)
• Regulatory failures allow risky practices to proliferate
  • Inadequate oversight of subprime mortgage lending
  • Lack of regulation for over-the-counter derivatives markets

Macroeconomic Imbalances and External Shocks

• Large current account deficits or unsustainable levels of public debt contribute to financial instability
  • Greece's sovereign debt crisis in 2009
  • Thailand's current account deficit before the 1997 Asian financial crisis
• Sudden shifts in investor sentiment trigger panic selling and liquidity crunches
  • "Flight to quality" during times of market stress
  • Bank runs (Northern Rock in the UK during 2007)
• External shocks act as catalysts for financial crises in vulnerable economies
  • Oil price shocks impacting oil-importing countries
  • Geopolitical events (Brexit vote in 2016 causing market volatility)

Financial Contagion and Transmission

Cross-Border Financial Linkages

• Financial contagion spreads market disturbances from one country to others through interconnected financial systems
  • Asian financial crisis of 1997-1998 spreading from Thailand to other Southeast Asian countries
• Global financial institutions act as conduits for contagion
  • Losses in one market force institutions to reduce exposure in others to maintain capital ratios
  • Lehman Brothers' collapse in 2008 affecting global financial markets
• Balance sheet effects increase the burden of foreign currency-denominated debt during currency depreciation
  • Mexican peso crisis of 1994 leading to increased debt burdens for Mexican companies

Investor Behavior and Economic Connections

• "Wake-up call" hypothesis leads investors to reassess risks in similar economies
  • Russian debt default in 1998 triggering reassessment of emerging market risks
• Information asymmetries and herding behavior among investors amplify contagion effects
  • Sudden capital outflows from emerging markets during periods of global uncertainty
• Trade linkages transmit economic shocks across borders
  • Recession in the United States reducing demand for imports from China and other trading partners
  • European debt crisis affecting exports from neighboring countries

Policy Responses to Financial Crises

Monetary and Fiscal Interventions

• Central banks employ monetary policy tools to provide liquidity and stabilize financial markets
  • Interest rate cuts by the Federal Reserve during the 2008 crisis
  • Quantitative easing programs implemented by the European Central Bank
• Governments implement fiscal stimulus measures to boost aggregate demand
  • American Recovery and Reinvestment Act of 2009 in the United States
  • China's economic stimulus plan during the global financial crisis
• Bank recapitalization and asset purchase programs shore up the financial sector
  • Troubled Asset Relief Program (TARP) in the United States
  • Bank bailouts in European countries during the Eurozone crisis

International Cooperation and Regulatory Reforms

• International financial institutions provide emergency lending and policy advice
  • IMF bailout packages for countries experiencing balance of payments crises (Greece, Argentina)
• Coordinated international responses mitigate global financial instability
  • Currency swap lines between central banks (Federal Reserve and ECB)
  • G20 coordinated fiscal stimulus efforts in 2009
• Regulatory reforms and enhanced supervision address systemic vulnerabilities
  • Basel III capital and liquidity requirements for banks
  • Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States

Long-Term Consequences of Financial Crises

Economic and Financial System Impacts

• Prolonged periods of sluggish economic growth, high unemployment, and reduced investment (secular stagnation)
  • Japan's "Lost Decade" following its 1990s financial crisis
  • Slow recovery in advanced economies after the 2008 global financial crisis
• Shifts in the global economic order accelerate the rise of emerging economies
  • Increased economic influence of China and other BRICS nations
• Accumulation of foreign exchange reserves by emerging markets as self-insurance
  • China's large holdings of US Treasury securities
• Persistent low interest rates create challenges for monetary policy
  • Negative interest rates in some European countries and Japan
  • Potential for new asset bubbles in a low-interest-rate environment

Institutional and Policy Changes

• Reforms in the international monetary system enhance coordination among central banks and regulatory authorities
  • Creation of the Financial Stability Board
  • Expansion of the IMF's lending capacity and surveillance role
• Public debt levels surge due to bailouts and stimulus measures
  • Increased debt-to-GDP ratios in many advanced economies
  • Potential constraints on future fiscal policy options
• Erosion of trust in financial institutions leads to increased financial fragmentation
  • Growth of shadow banking systems
  • Rise of cryptocurrencies and decentralized finance as alternatives to traditional banking