11.2 Case Studies of Major Financial Crises

Financial crises can wreak havoc on economies, as seen in the Asian Financial Crisis and Global Financial Crisis. These events exposed vulnerabilities in financial systems and led to widespread economic turmoil, affecting millions of people worldwide.

Both crises sparked major policy changes and international cooperation efforts. They highlighted the need for better financial regulation, more cautious approaches to liberalization, and stronger crisis prevention mechanisms to build economic resilience and stability.

Asian Financial Crisis and Global Financial Crisis

Asian Financial Crisis features

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• Causes of the crisis:
  • Rapid economic growth and financial liberalization in East Asian countries led to excessive risk-taking
  • Excessive borrowing and investment fueled asset bubbles (real estate, stocks)
  • Pegged exchange rates and currency mismatches made countries vulnerable to capital outflows
  • Weak financial regulation and oversight allowed for build-up of systemic risks
• Consequences of the crisis:
  • Sharp declines in asset prices and currency values eroded wealth and purchasing power
  • Widespread bankruptcies and economic contraction led to rising unemployment and social unrest
  • Contagion effect spreading to other countries in the region through trade and financial linkages
• Policy responses:
  • IMF-led bailouts with conditionality required countries to implement structural reforms (financial sector, corporate governance)
  • Adoption of flexible exchange rates and strengthened financial regulation to reduce vulnerabilities
  • Establishment of regional financial cooperation mechanisms (Chiang Mai Initiative) to provide support and prevent future crises
• Lessons learned:
  • Importance of sound macroeconomic policies and financial regulation to maintain stability
  • Need for caution in financial liberalization and managing capital flows to avoid excessive risk-taking
  • Benefits of regional cooperation and crisis prevention mechanisms to build resilience

Global Financial Crisis analysis

• Causes of the crisis:
  • Subprime mortgage lending and securitization in the U.S. led to a housing bubble and credit boom
  • Global imbalances and search for yield in a low-interest-rate environment fueled risk-taking
  • Inadequate financial regulation and risk management practices allowed for excessive leverage and complex financial products
  • Excessive leverage and interconnectedness of financial institutions amplified systemic risks
• Consequences of the crisis:
  • Collapse of major financial institutions (Lehman Brothers) triggered a global financial panic
  • Credit crunch and liquidity freeze in global financial markets disrupted lending and investment
  • Sharp declines in asset prices and economic activity worldwide led to the Great Recession
  • Sovereign debt crises in some European countries (Greece, Ireland) exacerbated the crisis
• Policy responses:
  • Unconventional monetary policies (quantitative easing, zero interest rates) to provide liquidity and support economic activity
  • Fiscal stimulus packages and bank bailouts to prevent a deeper recession and restore financial stability
  • Strengthening of financial regulation (Basel III, Dodd-Frank Act) to address systemic risks and improve resilience
  • International coordination through the G20 and Financial Stability Board to promote global financial stability
• Lessons learned:
  • Systemic risks posed by large, interconnected financial institutions require close monitoring and regulation
  • Importance of macroprudential regulation and monitoring systemic risks to prevent build-up of vulnerabilities
  • Need for effective crisis management and resolution frameworks to minimize the impact of future crises
  • Challenges of achieving a balanced and sustainable global recovery in the face of structural imbalances and policy constraints

Regional and Country-Specific Financial Crises

Regional vs country-specific crises

• Latin American debt crisis (1980s):
  • Caused by overborrowing, oil price shocks, and rising global interest rates, leading to a regionwide crisis
  • Led to debt defaults, economic contraction, and a "lost decade" of development for many countries in the region
• Russian financial crisis (1998):
  • Triggered by falling oil prices, fiscal imbalances, and political instability, with spillover effects to other former Soviet states
  • Resulted in debt default, ruble devaluation, and contagion to other emerging markets (Brazil)
• Argentine economic crisis (1999-2002):
  • Caused by unsustainable fiscal policies, overvalued currency, and external shocks, leading to a severe country-specific crisis
  • Led to debt default, currency devaluation, and severe economic contraction, with social and political unrest
• European sovereign debt crisis (2010-2012):
  • Triggered by high public debt, banking sector vulnerabilities, and structural imbalances in several EU countries
  • Affected countries like Greece, Ireland, Portugal, and Spain, requiring coordinated regional response and reforms

Effectiveness of international interventions

• IMF-led bailouts:
  • Provide emergency financing to countries facing balance of payments crises (Mexico 1994, South Korea 1997)
  • Often come with conditionality (structural reforms, austerity measures) to address underlying vulnerabilities
  • Can help restore market confidence and stabilize economies in the short term, but may have social and political costs
  • Criticized for imposing harsh conditions and exacerbating social costs, particularly in developing countries
• Regional financial arrangements:
  • Examples: European Stability Mechanism (EU), Chiang Mai Initiative Multilateralization (ASEAN+3)
  • Provide financial support and crisis management mechanisms at the regional level, complementing global institutions
  • Can tailor assistance to regional needs and promote regional cooperation and integration
  • Face challenges in terms of adequacy of resources and decision-making processes, particularly in heterogeneous regions
• Bilateral swap lines:
  • Temporary arrangements between central banks to provide foreign currency liquidity (U.S. Federal Reserve during GFC)
  • Played a key role in mitigating the Global Financial Crisis and subsequent crises by providing dollar liquidity
  • Help alleviate funding pressures and stabilize financial markets, particularly for countries with limited foreign reserves
  • Limited in scope and subject to political considerations, as they depend on the willingness of major central banks to provide support
• Effectiveness of interventions:
  • Depend on the nature and severity of the crisis, as well as the timeliness and adequacy of the response
  • Can help prevent contagion and restore market confidence in the short term, but may not address underlying structural issues
  • Long-term success requires addressing underlying vulnerabilities and implementing structural reforms to build resilience
  • International cooperation and coordination are crucial for effective crisis management, particularly in an interconnected global economy