11.1 Anatomy of Global Financial Crises

Global financial crises stem from economic imbalances, risky behavior, and market shifts. Unsustainable deficits, excessive debt, and overvalued currencies set the stage. Speculative bubbles, overleveraging, and sudden loss of confidence can trigger crises, often amplified by external shocks.

Financial institutions play a crucial role in crises through risk-taking and interconnectedness. Markets can amplify shocks, while complex instruments obscure risks. Crises spread globally via trade, finance, and confidence channels, causing economic downturns, fiscal pressures, and social upheaval.

Causes and Mechanisms of Global Financial Crises

Causes of global financial crises

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• Unsustainable economic imbalances develop when countries have
  • Large current account deficits occur when a country imports more than it exports and borrows to finance the difference (Greece, Portugal)
  • Excessive government debt accumulates when governments spend more than they collect in taxes and borrow heavily (Argentina, Lebanon)
  • Overvalued exchange rates make a country's exports less competitive and imports cheaper, leading to trade imbalances (Thailand, Malaysia during the Asian Financial Crisis)
• Excessive risk-taking in financial markets occurs when
  • Speculative bubbles in asset prices form as investors bid up the prices of assets beyond their fundamental value (housing market in the US before 2008, tech stocks in the late 1990s)
  • Overleveraging by financial institutions and investors involves borrowing heavily to invest, amplifying potential gains but also losses (investment banks like Lehman Brothers and Bear Stearns before 2008)
• Sudden shifts in market sentiment can trigger crises through
  • Loss of confidence in the solvency of borrowers or the stability of the financial system, leading to a rush to withdraw funds (bank runs during the Great Depression, Northern Rock in the UK in 2007)
  • Rapid withdrawal of funds by investors (capital flight) can deplete a country's foreign exchange reserves and make it difficult to maintain a fixed exchange rate (Mexico in 1994, Argentina in 2001)
• External shocks can trigger or exacerbate crises, such as
  • Sharp changes in commodity prices, particularly for countries dependent on commodity exports (Venezuela and Nigeria with oil price declines)
  • Contagion from crises in other countries can spread as investors reassess risks in similar markets (Asian Financial Crisis spreading from Thailand to Indonesia and South Korea)

Role of financial institutions in crises

• Financial markets provide a platform for the trading of financial assets and can
  • Amplify shocks through rapid price adjustments and liquidity droughts, making it difficult for borrowers to access funds (stock market crashes, bond market sell-offs)
• Financial institutions like banks, investment firms, and other intermediaries facilitate financial transactions but can contribute to crises through
  • Excessive risk-taking, such as investing in complex, opaque securities (collateralized debt obligations before 2008)
  • Overleveraging, or borrowing heavily to invest, which can lead to insolvency if asset values decline sharply (Lehman Brothers, Bear Stearns)
  • Interconnectedness, where the failure of one institution can spread to others due to a web of loans, investments, and derivatives contracts (AIG's role in the 2008 crisis)
• Financial instruments can contribute to crises in several ways:
  • Complex derivatives like credit default swaps can obscure risks and create systemic vulnerabilities (role of AIG in the 2008 crisis)
  • Securitization of loans, or packaging them into tradable securities, can spread risks across the financial system and make them harder to identify and manage (subprime mortgage-backed securities before 2008)

Transmission and Consequences of Global Financial Crises

Cross-border transmission of shocks

• Trade linkages can spread economic downturns as
  • Reduced demand for exports in crisis-hit countries spreads to their trading partners (impact of US recession on Chinese exports in 2008-09)
• Financial linkages can transmit shocks across borders through
  • Cross-border investments and lending, exposing investors and banks to losses (European banks' exposure to Greek debt in the Eurozone crisis)
  • Contagion, as investors reassess risks in similar countries or markets and withdraw funds (impact of Thai baht devaluation on other Southeast Asian currencies in 1997)
• Confidence channels can spread crises as
  • Loss of confidence in one country leads to a reassessment of risks in other countries with similar characteristics (impact of Greek debt crisis on other heavily-indebted European countries like Italy and Spain)
• Policy responses to a crisis in one country can have spillover effects, such as
  • Monetary policy easing in major economies leading to capital inflows and currency appreciation in emerging markets (impact of US quantitative easing on Brazil and other emerging economies after 2008)

Consequences of financial crises

• Economic consequences can be severe and long-lasting, including
  1. Reduced economic growth and increased unemployment as businesses fail and investment declines (global recession after 2008 crisis)
  2. Fiscal pressures from reduced tax revenues and increased social spending, potentially leading to sovereign debt crises if governments are unable to service their debts (Greece, Ireland, Portugal in the Eurozone crisis)
• Social consequences can be significant, particularly for vulnerable groups, including
  • Increased poverty and inequality as job losses and reduced social spending hit low-income households hardest (impact of Asian Financial Crisis on poverty in Indonesia and Thailand)
  • Potential for social unrest and political instability as public anger grows over economic hardship and perceived unfairness (protests in Greece during the Eurozone crisis)
• Political consequences can reshape the domestic and international landscape, including
  • Pressure on governments to respond to the crisis and support affected groups, potentially leading to political turnover or changes in economic policy direction (electoral victories of left-wing parties in Latin America after the 1990s debt crises)
  • Increased tensions between countries as they seek to protect their own interests, such as through trade barriers or competitive currency devaluations (US-China tensions during the global financial crisis)