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115-396: Heterodox A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics , and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and

230-433: A floating (flexible) exchange regime . This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP . A fixed exchange rate system can also be used to control the behavior of a currency, such as by limiting rates of inflation . However, in doing so,

345-447: A self-fulfilling prophecy . Indeed, Robert K. Merton , who coined the term self-fulfilling prophecy , mentioned bank runs as a prime example of the concept in his book Social Theory and Social Structure . Mervyn King , governor of the Bank of England, once noted that it may not be rational to start a bank run, but it is rational to participate in one once it had started. A bank run is

460-517: A bank reorganization. Bank runs first appeared as a part of cycles of credit expansion and its subsequent contraction. From the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests, plummeting parts of the country into famine and unrest. Other examples are the Dutch tulip manias (1634–37), the British South Sea Bubble (1717–19),

575-506: A challenge to the epistemic norms typically assumed within financial economics and all of empirical finance. The possibility of financial crises being beyond the predictive reach of causality is discussed further within Epistemology of finance . Leverage , which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial institution (or an individual) only invests its own money, it can, in

690-527: A country is wiped out. The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down. According to former U.S. Federal Reserve chairman Ben Bernanke , the Great Depression was caused by the failure of the Federal Reserve System to prevent deflation, and much of the economic damage

805-431: A crisis is triggered by unsustainable fiscal policies, expansionary fiscal policies are typically used. In crises of liquidity and solvency, central banks can provide liquidity to support illiquid banks. Depositor protection can help restore confidence, although it tends to be costly and does not necessarily speed up economic recovery. Intervention is often delayed in the hope that recovery will occur, and this delay increases

920-402: A currency of at least 25% but it is also defined as at least a 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation . A speculative bubble (also called

1035-418: A devaluation crisis, is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as occurring when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of

1150-399: A few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called "strategic complementarity"), but because investors come to believe the true asset value is high when they observe others buying. In "herding" models, it is assumed that investors are fully rational, but only have partial information about the economy. In these models, when

1265-441: A few investors buy some type of asset, this reveals that they have some positive information about that asset, which increases the rational incentive of others to buy the asset too. Even though this is a fully rational decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a crash) since the first investors may, by chance, have been mistaken. Herding models, based on Complexity Science , indicate that it

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1380-401: A financial bubble or an economic bubble) exists in the event of large, sustained overpricing of some class of assets. One factor that frequently contributes to a bubble is the presence of buyers who purchase an asset based solely on the expectation that they can later resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is also

1495-404: A financial crisis. To facilitate his analysis, Minsky defines three approaches that financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility. Financial fragility levels move together with the business cycle . After a recession , firms have lost much financing and choose only hedge,

1610-473: A fixed exchange rate may be stable for a long period of time, but will collapse suddenly in an avalanche of currency sales in response to a sufficient deterioration of government finances or underlying economic conditions. According to some theories, positive feedback implies that the economy can have more than one equilibrium . There may be an equilibrium in which market participants invest heavily in asset markets because they expect assets to be valuable. This

1725-407: A fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in

1840-424: A fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money), which can lead to unemployment . Finally, other countries with a fixed exchange rate can also retaliate in response to a certain country using the currency of theirs in defending their exchange rate. The belief that the fixed exchange rate regime brings with it stability

1955-470: A fixed exchange-rate regime is the possibility of the central bank running out of foreign exchange reserves when trying to maintain the peg in the face of demand for foreign reserves exceeding their supply. This is called a currency crisis or balance of payments crisis, and when it happens the central bank must devalue the currency. When there is the prospect of this happening, private-sector agents will try to protect themselves by decreasing their holdings of

2070-399: A free hand. For instance, by using reflationary tools to set the economy growing faster (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper. Additionally, the stubbornness of a government in defending

2185-403: A government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far above the fixed benchmark rate (it is stronger than required), the government sells its own currency (which increases supply) and buys foreign currency. This causes

2300-406: A larger fraction of unbooked losses; if it rolls over its liabilities at increased interest rates, it squeezes its profits along with the profits of healthier competitors. The longer the silent run goes on, the more benefits are transferred from healthy banks and taxpayers to the zombie banks. The term is also used when many depositors in countries with deposit insurance draw down their balances below

2415-484: A potentially fatal run on a fictitious US bank. A run on a bank is one of the many causes of the characters' suffering in Upton Sinclair's The Jungle . In The Simpsons season 6 episode 21 The PTA Disbands has Bart Simpson starting a hush whisper campaign at the Bank of Springfield as a prank to instigate a bank run. The bank run is not shown, instead the bank manager, who bears resemblance to Jimmy Stewart, says

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2530-697: A risk of sovereign default due to fluctuations in exchange rates. Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. Behavioural finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'. Historians, notably Charles P. Kindleberger , have pointed out that crises often follow soon after major financial or technical innovations that present investors with new types of financial opportunities, which he called "displacements" of investors' expectations. Early examples include

2645-489: A risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to predict whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur. Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include

2760-668: A run on the banks under the rallying cry "Stop the Duke, go for gold!". Many of the recessions in the United States were caused by banking panics. The Great Depression contained several banking crises consisting of runs on multiple banks from 1929 to 1933; some of these were specific to regions of the U.S. Bank runs were most common in states whose laws allowed banks to operate only a single branch, dramatically increasing risk compared to banks with multiple branches particularly when single-branch banks were located in areas economically dependent on

2875-485: A run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance. An event in which bank runs are widespread is called a systemic banking crisis or banking panic . Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises generally occur after periods of risky lending and resulting loan defaults. A currency crisis, also called

2990-542: A scale matching or exceeding the bank's geographical area of operation, depositors' unpredictable needs for cash are unlikely to occur at the same time; that is, by the law of large numbers , banks can expect only a small percentage of accounts withdrawn on any one day because individual expenditure needs are largely uncorrelated . A bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors who may demand withdrawals. However, if many depositors withdraw all at once,

3105-667: A single industry. Banking panics began in the Southern United States in November 1930, one year after the stock market crash, triggered by the collapse of a string of banks in Tennessee and Kentucky , which brought down their correspondent networks. In December, New York City experienced massive bank runs that were contained to the many branches of a single bank. Philadelphia was hit a week later by bank runs that affected several banks, but were successfully contained by quick action by

3220-427: A small profit could be made with little or no capital. However, when interest rates changed and the incentive for the flow was removed or reversed sudden changes in capital flows could occur. The subjects of investment might be starved of cash possibly becoming insolvent and creating a credit crunch and the loaning banks would be left with defaulting investors leading to a banking crisis. As Charles Read has pointed out,

3335-449: A trade deficit occurs under a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur. Another major disadvantage of

3450-431: A valuable service by aggregating funds from many individual deposits, portioning them into loans for borrowers, and spreading the risks both of default and sudden demands for cash. Banks can charge much higher interest on their long-term loans than they pay out on demand deposits, allowing them to earn a profit. If only a few depositors withdraw at any given time, this arrangement works well. Barring some major emergency on

3565-415: A voluntary arrangement between two countries, as it is also possible for a country to link its currency to another countries currency without the consent of the other country. Various forms of monetary co-operations exist, which range from fixed parity systems to monetary unions . Also, numerous institutions have been established to enforce monetary co-operation and to stabilise exchange rates , including

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3680-605: Is based on the work of Thomas Tooke , Thomas Attwood , Henry Thornton , William Jevons and a number of bankers opposed to the Bank Charter Act 1844 . Starting at a time when short-term interest rates are low, frustration builds up among investors who search for a better yield in countries and locations with higher rates, leading to increased capital flows to countries with higher rates. Internally, short-term rates rise above long-term rates causing failures where borrowing at short term rates has been used to invest long-term where

3795-459: Is called a currency crisis or balance of payments crisis . When a country fails to pay back its sovereign debt , this is called a sovereign default . While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight . Several currencies that formed part of

3910-462: Is called a recession . An especially prolonged or severe recession may be called a depression , while a long period of slow but not necessarily negative growth is sometimes called economic stagnation . Some economists argue that many recessions have been caused in large part by financial crises. One important example is the Great Depression , which was preceded in many countries by bank runs and stock market crashes. The subprime mortgage crisis and

4025-496: Is focussed on currency linkages. A monetary union is considered to be the crowning step of a process of monetary co-operation and economic integration . In the form of monetary co-operation where two or more countries engage in a mutually beneficial exchange, capital among the countries involved is free to move, in contrast to capital controls . Monetary co-operation is considered to promote balanced economic growth and monetary stability, but can also work counter-effectively if

4140-425: Is little consensus and financial crises continue to occur from time to time. It is apparent however that a consistent feature of both economic (and other applied finance disciplines) is the obvious inability to predict and avert financial crises. This realization raises the question as to what is known and also capable of being known (i.e. the epistemology ) within economics and applied finance. It has been argued that

4255-498: Is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements , capital requirements , and other limits on leverage . Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the former Managing Director of the International Monetary Fund , Dominique Strauss-Kahn , has blamed

4370-540: Is often delayed in the hope that insolvent banks will recover if given liquidity support and relaxation of regulations, and in the end this delay increases stress on the economy. Programs that are targeted, that specify clear quantifiable rules that limit access to preferred assistance, and that contain meaningful standards for capital regulation, appear to be more successful. According to IMF, government-owned asset management companies ( bad banks ) are largely ineffective due to political constraints. A silent run occurs when

4485-498: Is scarce, potentially aggravating a financial crisis. International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding (discussed above) and so increasing systemic risk. From this perspective, maintaining diverse regulatory regimes would be a safeguard. Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled

4600-571: Is taxed by government and returned to the mass of people in the form of welfare, family benefits and health and education spending; and secondly, the proportion of the population who are workers rather than investors/business owners. Given the extraordinary capital expenditure required to enter modern economic sectors like airline transport, the military industry, or chemical production, these sectors are extremely difficult for new businesses to enter and are being concentrated in fewer and fewer hands. Empirical and econometric research continues especially in

4715-460: Is the internal structure of the market, not external influences, which is primarily responsible for crashes. In "adaptive learning" or "adaptive expectations" models, investors are assumed to be imperfectly rational, basing their reasoning only on recent experience. In such models, if the price of a given asset rises for some period of time, investors may begin to believe that its price always rises, which increases their tendency to buy and thus drives

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4830-556: Is the pegging of money to a certain amount of gold. Currency board arrangements are the most widespread means of fixed exchange rates. Currency boards are considered hard pegs as they allow central banks to cope with shocks to money demand without running out of reserves. CBAs have been operational in many nations including: Monetary co-operation is the mechanism in which two or more monetary policies or exchange rates are linked, and can happen at regional or international level. The monetary co-operation does not necessarily need to be

4945-651: Is the type of argument underlying Diamond and Dybvig's model of bank runs , in which savers withdraw their assets from the bank because they expect others to withdraw too. Likewise, in Obstfeld's model of currency crises , when economic conditions are neither too bad nor too good, there are two possible outcomes: speculators may or may not decide to attack the currency depending on what they expect other speculators to do. A variety of models have been developed in which asset values may spiral excessively up or down as investors learn from each other. In these models, asset purchases by

5060-604: The European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997–98 . Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds. Negative GDP growth lasting two or more quarters

5175-533: The European Monetary Cooperation Fund (EMCF) in 1973 and the International Monetary Fund (IMF) Monetary co-operation is closely related to economic integration , and are often considered to be reinforcing processes. However, economic integration is an economic arrangement between different regions, marked by the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies , whereas monetary co-operation

5290-412: The International Monetary Fund (IMF) in 1978 that gave a smaller role to gold in the international monetary system, this fixed parity system as a monetary co-operation policy was terminated. The Thai government amended its monetary policies to be more in line with the new IMF policy. One main criticism of a fixed exchange rate is that flexible exchange rates serve to adjust the balance of trade . When

5405-466: The Mundell–Fleming model , with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability. In a fixed exchange rate system, a country's central bank typically uses an open market mechanism and is committed at all times to buy and sell its currency at a fixed price in order to maintain its pegged ratio and, hence,

5520-544: The People's Republic of China , which, in July 2005, adopted a slightly more flexible exchange rate system, called a managed exchange rate . The European Exchange Rate Mechanism is also used on a temporary basis to establish a final conversion rate against the euro from the local currencies of countries joining the Eurozone . Timeline of the fixed exchange rate system: Typically,

5635-505: The South Sea Bubble and Mississippi Bubble of 1720, which occurred when the notion of investment in shares of company stock was itself new and unfamiliar, and the Crash of 1929 , which followed the introduction of new electrical and transportation technologies. More recently, many financial crises followed changes in the investment environment brought about by financial deregulation , and

5750-431: The bursting of other financial bubbles , currency crises , and sovereign defaults . Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy (for example, the crisis resulting from the famous tulip mania bubble in the 17th century). Many economists have offered theories about how financial crises develop and how they could be prevented. There

5865-693: The financial crisis of 2007–2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'. Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis. However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital

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5980-470: The stock market (" margin buying ") became increasingly common prior to the Wall Street Crash of 1929 . Another factor believed to contribute to financial crises is asset-liability mismatch , a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts that can be withdrawn at any time, and they use

6095-421: The world systems theory and in the debate about Nikolai Kondratiev and the so-called 50-years Kondratiev waves . Major figures of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein , consistently warned about the crash that the world economy is now facing. World systems scholars and Kondratiev cycle researchers always implied that Washington Consensus oriented economists never understood

6210-599: The 17th century Dutch tulip mania , the 18th century South Sea Bubble , the Wall Street Crash of 1929 , the Japanese property bubble of the 1980s, and the crash of the United States housing bubble during 2006–2008. The 2000s sparked a real estate bubble where housing prices were increasing significantly as an asset good. When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency due to accruing an unsustainable current account deficit, this

6325-568: The 1930s, even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s . The 2007–2008 financial crisis was centered around market-liquidity failures that were comparable to a bank run. The crisis contained a wave of bank nationalizations, including those associated with Northern Rock of the UK and IndyMac of the U.S. This crisis was caused by low real interest rates stimulating an asset price bubble fuelled by new financial products that were not stress tested and that failed in

6440-485: The 2008 subprime mortgage crisis ; government officials stated on 23 September 2008 that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac , Lehman Brothers , and insurer American International Group . Likewise it has been argued that many financial companies failed in the recent crisis because their managers failed to carry out their fiduciary duties. Contagion refers to

6555-606: The French Mississippi Company (1717–20), the post-Napoleonic depression (1815–30), and the Great Depression (1929–39). Bank runs have also been used to blackmail individuals and governments. In 1832, for example, the British government under the Duke of Wellington overturned a majority government on the orders of the king, William IV , to prevent reform (the later Reform Act 1832 ( 2 & 3 Will. 4 . c. 45)). Wellington's actions angered reformers, and they threatened

6670-689: The Netherlands, participated in an arrangement called the Snake . This arrangement is categorized as exchange rate co-operation. During the next 6 years, this agreement allowed the currencies of the participating countries to fluctuate within a band of plus or minus 2¼% around pre-announced central rates . Later, in 1979, the European Monetary System (EMS) was founded, with the participating countries in ‘the Snake’ being founding members. The EMS evolves over

6785-415: The actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed. The Banking School theory of crises describes a continuous cycle driven by varying interest rates. It

6900-475: The assumptions of unique, well-defined causal chains being present in economic thinking, models and data, could, in part, explain why financial crises are often inherent and unavoidable. When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run . Since banks lend out most of the cash they receive in deposits (see fractional-reserve banking ), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so

7015-420: The bank itself (as opposed to individual investors) may run short of liquidity, and depositors will rush to withdraw their money, forcing the bank to liquidate many of its assets at a loss, and eventually to fail. If such a bank were to attempt to call in its loans early, businesses might be forced to disrupt their production while individuals might need to sell their homes and/or vehicles, causing further losses to

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7130-667: The benefits of collective prevention are commonly believed to outweigh the costs of excessive risk-taking. Techniques to deal with a banking panic when prevention have failed: The bank panic of 1933 is the setting of Archibald MacLeish 's 1935 play, Panic . Other fictional depictions of bank runs include those in American Madness (1932), It's a Wonderful Life (1946, set in 1932 U.S.), Silver River (1948), Mary Poppins (1964, set in 1910 London), Rollover (1981), Noble House (1988) and The Pope Must Die (1991). Arthur Hailey 's novel The Moneychangers includes

7245-468: The bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that

7360-625: The circular relationships often evident in social systems between cause and effect – and relates to the property of self-referencing in financial markets. George Soros has been a proponent of the reflexivity paradigm surrounding financial crises. Similarly, John Maynard Keynes compared financial markets to a beauty contest game in which each participant tries to predict which model other participants will consider most beautiful. Furthermore, in many cases, investors have incentives to coordinate their choices. For example, someone who thinks other investors want to heavily buy Japanese yen may expect

7475-415: The crash of the dot com bubble in 2001 arguably began with "irrational exuberance" about Internet technology. Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values. Also, if the first investors in a new class of assets (for example, stock in "dot com" companies) profit from rising asset values as other investors learn about

7590-410: The current financial system . Bank run#Systemic banking crises A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether. A systemic banking crisis is one where all or almost all of the banking capital in

7705-445: The cycle restarts from the beginning. Mathematical approaches to modeling financial crises have emphasized that there is often positive feedback between market participants' decisions (see strategic complementarity ). Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals. For example, some models of currency crises (including that of Paul Krugman ) imply that

7820-413: The dangers and perils, which leading industrial nations will be facing and are now facing at the end of the long economic cycle which began after the oil crisis of 1973. Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy . High fragility leads to a higher risk of

7935-436: The domestic currency and increasing their holdings of the foreign currency, which has the effect of increasing the likelihood that the forced devaluation will occur. A forced devaluation will change the exchange rate by more than the day-by-day exchange rate fluctuations under a flexible exchange rate system. Moreover, a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with

8050-402: The domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate. In the 21st century, the currencies associated with large economies typically do not fix (peg) their exchange rates to other currencies. The last large economy to use a fixed exchange rate system was

8165-598: The downturn. Under fractional-reserve banking , the type of banking currently used in most developed countries , banks retain only a fraction of their demand deposits as cash. The remainder is invested in securities and loans , whose terms are typically longer than the demand deposits, resulting in an asset–liability mismatch . No bank has enough reserves on hand to cope with all deposits being taken out at once. Diamond and Dybvig developed an influential model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. According to

8280-544: The economy. These theoretical ideas include the ' financial accelerator ', ' flight to quality ' and ' flight to liquidity ', and the Kiyotaki-Moore model . Some 'third generation' models of currency crises explore how currency crises and banking crises together can cause recessions. Austrian School economists Ludwig von Mises and Friedrich Hayek discussed the business cycle starting with Mises' Theory of Money and Credit , published in 1912. Recurrent major depressions in

8395-516: The fall 1930 bank runs and forced banks to liquidate loans, which directly caused a decrease in the money supply , shrinking the economy. Bank runs continued to plague the United States for the next several years. Citywide runs hit Boston (December 1931), Chicago (June 1931 and June 1932), Toledo (June 1931), and St. Louis (January 1933), among others. Institutions put into place during the Depression have prevented runs on U.S. commercial banks since

8510-547: The first four years of the crisis. Several techniques have been used to help prevent or mitigate bank runs. Some prevention techniques apply to individual banks, independently of the rest of the economy. Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail. The role of the lender of last resort, and the existence of deposit insurance, both create moral hazard , since they reduce banks' incentive to avoid making risky loans. They are nonetheless standard practice, as

8625-408: The form of wages) than the value of the goods produced by those workers (i.e. the amount of money the products are sold for). This profit first goes towards covering the initial investment in the business. In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money (in the form of wages) is being returned to the mass of

8740-507: The funds cannot be liquidated quickly (a similar mechanism was implicated in the March 2023 failure of SVB Bank ). Internationally, arbitrage and the need to stop capital flows, which caused bullion drains in the gold standard of the nineteenth century and drains of foreign capital later, bring interest rates in the low-rate country up to equal those in the country which is the subject of investment. The capital flows reverse or cease suddenly causing

8855-441: The idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk . One widely cited example of contagion

8970-431: The implicit fiscal deficit from a government's unbooked loss exposure to zombie banks is large enough to deter depositors of those banks. As more depositors and investors begin to doubt whether a government can support a country's banking system, the silent run on the system can gather steam, causing the zombie banks' funding costs to increase. If a zombie bank sells some assets at market value, its remaining assets contain

9085-497: The initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve, a position supported by Ben Bernanke . It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. Reflexivity refers to

9200-499: The innovation (in our example, as others learn about the potential of the Internet), then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such " herd behaviour " causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are not assured, then

9315-416: The larger economy. Even so, many, if not most, debtors would be unable to pay the bank in full on demand and would be forced to declare bankruptcy , possibly affecting other creditors in the process. A bank run can occur even when started by a false story. Even depositors who know the story is false will have an incentive to withdraw, if they suspect other depositors will believe the story. The story becomes

9430-658: The leading city banks and the Federal Reserve Bank . Withdrawals became worse after financial conglomerates in New York and Los Angeles failed in prominently-covered scandals. Much of the US Depression's economic damage was caused directly by bank runs, though Canada had no bank runs during this same era due to different banking regulations. Milton Friedman and Anna Schwartz argued that steady withdrawals from banks by nervous depositors ("hoarding") were inspired by news of

9545-575: The lender. The same principle applies to individuals and households seeking financing to purchase large-ticket items such as housing or automobiles . The households and firms who have the money to lend to these businesses may have sudden, unpredictable needs for cash, so they are often willing to lend only on the condition of being guaranteed immediate access to their money in the form of liquid demand deposit accounts , that is, accounts with shortest possible maturity. Since borrowers need money and depositors fear to make these loans individually, banks provide

9660-408: The limit for deposit insurance. The cost of cleaning up after a crisis can be huge. In systemically important banking crises in the world from 1970 to 2007, the average net recapitalization cost to the government was 6% of GDP , fiscal costs associated with crisis management averaged 13% of GDP (16% of GDP if expense recoveries are ignored), and economic output losses averaged about 20% of GDP during

9775-561: The market and causes the local currency to become stronger, hopefully back to its intended value. The reserves they sell may be the currency it is pegged to, in which case the value of that currency will fall. Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This

9890-543: The member countries have (strongly) differing levels of economic development . Especially European and Asian countries have a history of monetary and exchange rate co-operation, however the European monetary co-operation and economic integration eventually resulted in a European monetary union . In 1973, the currencies of the European Economic Community countries, Belgium, France, Germany, Italy, Luxemburg and

10005-427: The model, business investment requires expenditures in the present to obtain returns that take time in coming, for example, spending on machines and buildings now for production in future years. A business or entrepreneur that needs to borrow to finance investment will want to give their investments a long time to generate returns before full repayment, and will prefer long maturity loans, which offer little liquidity to

10120-408: The model, the bank acts as an intermediary between borrowers who prefer long-maturity loans and depositors who prefer liquid accounts. The Diamond–Dybvig model provides an example of an economic game with more than one Nash equilibrium , where it is logical for individual depositors to engage in a bank run once they suspect one might start, even though that run will cause the bank to collapse. In

10235-505: The modern equivalent of this process involves the Carry Trade, see Carry (investment) . Some financial crises have little effect outside of the financial sector, like the Wall Street crash of 1987 , but other crises are believed to have played a role in decreasing growth in the rest of the economy. There are many theories why a financial crisis could have a recessionary effect on the rest of

10350-428: The money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand

10465-677: The next decade and even results into a truly fixed exchange rate at the start of the 1990s. Around this time, in 1990, the EU introduced the Economic and Monetary Union (EMU), as an umbrella term for the group of policies aimed at converging the economies of member states of the European Union over three phases In 1963, the Thai government established the Exchange Equalization Fund (EEF) with

10580-422: The organization of central banks that act as a lender of last resort , the protection of deposit insurance systems such as the U.S. Federal Deposit Insurance Corporation , and after a run has started, a temporary suspension of withdrawals. These techniques do not always work: for example, even with deposit insurance, depositors may still be motivated by beliefs they may lack immediate access to deposits during

10695-452: The pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the values of any currencies pegged to it will also rise and fall in relation to other currencies and commodities with which the pegged currency can be traded. In other words, a pegged currency is dependent on its reference value to dictate how its current worth is defined at any given time. In addition, according to

10810-410: The population (the workers) than is available to them to buy all of these goods being produced. Furthermore, the expansion of businesses in the process of competing for markets leads to an abundance of goods and a general fall in their prices, further exacerbating the tendency for the rate of profit to fall . The viability of this theory depends upon two main factors: firstly, the degree to which profit

10925-426: The price of the currency to decrease in value (Read: Classical Demand-Supply diagrams). Also, if they buy the currency it is pegged to, then the price of that currency will increase, causing the relative value of the currencies to approach what is intended. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market by selling its reserves. This places greater demand on

11040-545: The price up further. Likewise, observing a few price decreases may give rise to a downward price spiral, so in models of this type, large fluctuations in asset prices may occur. Agent-based models of financial markets often assume investors act on the basis of adaptive learning or adaptive expectations. As the most recent and most damaging financial crisis event, the Global financial crisis, deserves special attention, as its causes, effects, response, and lessons are most applicable to

11155-401: The proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reasons bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Likewise, Bear Stearns failed in 2007–08 because it

11270-449: The purpose of playing a role in stabilizing exchange rate movements. It linked to the U.S. dollar by fixing the amount of gram of gold per baht as well as the baht per U.S. dollar. Over the course of the next 15 years, the Thai government decided to depreciate the baht in terms of gold three times, yet maintain the parity of the baht against the U.S. dollar. Due to the introduction of a new generalized floating exchange rate system by

11385-660: The resulting income. Examples include Charles Ponzi 's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that led to the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in 2008. Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of

11500-471: The safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all

11615-422: The same thing they expect others to do, then self-fulfilling prophecies may occur. For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail. Therefore, financial crises are sometimes viewed as a vicious circle in which investors shun some institution or asset because they expect others to do so. Reflexivity poses

11730-437: The savings are in other people's houses, spoofing It's a Wonderful Life . Fixed exchange rate A fixed exchange rate , often called a pegged exchange rate , is a type of exchange rate regime in which a currency 's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies , or another measure of value, such as gold . There are benefits and risks to using

11845-425: The spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices. Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency : making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation

11960-439: The stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of

12075-425: The stress on the economy. Some measures are more effective than others in containing economic fallout and restoring the banking system after a systemic crisis. These include establishing the scale of the problem, targeted debt relief programs to distressed borrowers, corporate restructuring programs, recognizing bank losses, and adequately capitalizing banks. Speed of intervention appears to be crucial; intervention

12190-456: The subject of investment to be starved of funds and the remaining investors (often those who are least knowledgeable) to be left with devalued assets. Bankruptcies, defaults and bank failures follow as rates are pushed high. After the crisis governments push short-term interest rates low again to diminish the cost of servicing government borrowing which has been used to overcome the crisis. Funds build up again looking for investment opportunities and

12305-663: The sudden withdrawal of deposits of just one bank. A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as a cascading failure . In a systemic banking crisis , all or almost all of the banking capital in a country is wiped out; this can result when regulators ignore systemic risks and spillover effects . Systemic banking crises are associated with substantial fiscal costs and large output losses. Frequently, emergency liquidity support and blanket guarantees have been used to contain these crises, not always successfully. Although fiscal tightening may help contain market pressures if

12420-558: The tendency for the rate of profit to fall borrowed many features of the presentation of John Stuart Mill 's discussion Of the Tendency of Profits to a Minimum (Principles of Political Economy Book IV Chapter IV). The theory is a corollary of the Tendency towards the Centralization of Profits . In a capitalist system, successfully-operating businesses return less money to their workers (in

12535-515: The very worst case, lose its own money. But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore, leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy . Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another (see 'Contagion' below). For example, borrowing to finance investment in

12650-399: 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. Developing an economic crisis theory became the central recurring concept throughout Karl Marx 's mature work. Marx's law of

12765-478: The yen to rise in value, and therefore has an incentive to buy yen, too. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw, too. Economists call an incentive to mimic the strategies of others strategic complementarity . It has been argued that if people or firms have a sufficiently strong incentive to do

12880-508: Was caused directly by bank runs. The cost of cleaning up a systemic banking crisis can be huge, with fiscal costs averaging 13% of GDP and economic output losses averaging 20% of GDP for important crises from 1970 to 2007. Several techniques have been used to try to prevent bank runs or mitigate their effects. They have included a higher reserve requirement (requiring banks to keep more of their reserves as cash), government bailouts of banks, supervision and regulation of commercial banks,

12995-457: Was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. China buys an average of one billion US dollars a day to maintain the currency peg. Throughout the 1990s, China was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies. The gold standard

13110-730: Was the spread of the Thai crisis in 1997 to other countries like South Korea . However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages. The nineteenth century Banking School theory of crises suggested that crises were caused by flows of investment capital between areas with different rates of interest. Capital could be borrowed in areas with low interest rates and invested in areas of high interest. Using this method

13225-449: Was unable to renew the short-term debt it used to finance long-term investments in mortgage securities. In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run

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