According to the neoclassical economic school of thought, capitalist economies are cyclical in nature (Claessens, Kose, Laeven and Valenci 2). A period of growth is usually accompanied with a big decline in economic. However, although the boom and bust aspects of the capitalist economy are somewhat predictable in general, what can’t be predicted is how long the boom and bust period will last, when the boom and bust period will occur, and how sharp the decline of them will be. Nevertheless, some commentators have pointed out that financial crises which means extremely sharp drops in economic activity are avoidable and it even can be predicted (Claessens, Kose, Laeven and Valenci 2).
There are three purposes of this paper. Firstly, I will use the examples of the 1997 Asian Crisis and the Global Financial Crisis of 2007-2008, and I will identify the causes of financial crises. Secondly, I will consider about the effect of the financial crises on national and international markets. At last, I will pay attention on the policy responses and recovery times from these financial crises, and discussion also focus on contagion effects and how we may avoid them. For these topics, I will try to solve these following questions: What can individual countries do, when the globe is in financial crisis, to avoid their economy from the demise of the economies of other countries in the globe? What are the different sectors in an economy that can determine whether the economy is in a healthy position or not? What techniques can countries use to predict future financial crisis? Finally, the goal of the paper is to understand what can be done by policymakers to recognize the beginnings of a crisis, to take corrective action when a crisis has started and to avoid financial crises in the future.
First of all, What are financial crises? Before discussing the causes of financial crises, it is necessary to provide a definition and clarification that what is meant by a financial crisis. Although financial crises do differ in terms of their precise causes, effects, consequences and global reach, commentators do agree that there are characteristics that are shared between them, facilitating the classification of an economic downturn into a financial crisis (Claessens et al 3).
One of the most comprehensive description of a financial crisis is provided by Eichengreen and Portes in ‘anatomy of financial crises’. They define a financial crisis as “a disturbance to financial markets. associated typically with falling asset prices and insolvency among debtors and intermediaries, which spreads through the financial system, disrupting the market’s capacity to allocate capital” (Eichengreen and Portes 10). What’s more, they suggest that there are a lot of similar features across crises. Firstly, there are debt defaults that are systemic and widely shared across the financial sector. Secondly, there are disturbances in international capital markets and in foreign exchange systems (Eichengreen and Portes 12). Thirdly, these twin effects cause bank failures which are not isolated, but which also occur through panic and contagion that is facilitated by highly interconnected financial services markets.
Moro has also discussed the characteristics of financial crises (3-27). Moro argues that because of asymmetric information between different actors in the financial markets and consumers, along with the illiquidity in the banking sector more generally, then the panic ensues in the market, which will cause a recession. When there is an increase in the demand for liquid assets, the assets of those intermediaries that are responsible for supplying that liquidity decreases, while the value of their liabilities increase. It is the actions that these developments prompt which causes the panic that brings about the crisis:
“To restore their own financial equilibrium, those intermediaries sell their assets in a situation where buyers are relatively fewer. Securities prices fall further, and this causes the “panic”, the “flight to quality”, the “run”, or whatever one chooses to call it. Short-term credit dries up, including the normally straightforward repurchase agreement (“the run on repo”), interbank lending, and commercial paper markets. This panic is usually followed by a very sharp recession”. (Moro 3).
In next section, I will discuss two of the most prominent and disastrous financial crises in modern history, which are the Asian Financial Crisis (1997) and the Global Financial Crisis (2007 – 2008). It will be shown that the characteristics were in both of these crises.
Firstly, what are the causes of the Asian Financial Crisis (1997) and the Global Financial Crisis (2007 – 2008). In the mid 1980s, several Asian nations, who eventually collectively came to be known as the ‘Asian Tigers’, began to record a level of growth that the World Bank, and other commentators described as miraculous(Krugman 63). After several years of sluggish growth, when these economies languished in the lower echelons of the developing nation hierarchies, countries such as South Korea and Taiwan began to record growth levels in the double digits. The specific policies that were pursued by the government and other relevant authorities (e.g. central banks) in each of these countries was very different (Krugman 63). However, the same thing was a turn towards the global economy, with exports of consumer goods the main driver of growth in Gross Domestic Product (GDP).
The celebration ended in July 1997 when speculative attacks were levied on the Thai baht (Corsetti, Pesenti and Roubini 307). Just like Moro (3) predicted in his discussion about the causes of financial crisis, investors began to sell of assets denominated in the local currency. The Thai baht, which had been pegged to the US dollars in order to support the country’s export orientation, had to be floated because the Thai government did not have sufficient currency reserves to support a fixed exchange rate (Corsetti et al. 307). On the 2nd July, the baht was floated and lost 13.5 per cent of its value in the same day. By the end of July, the currency was only worth 23 percent of its previous value (Corsetti et al. 307). The pressure that was placed on the Thai baht spread quickly to neighboring economies, and the currencies of Malaysia, Indonesia, South Korea and the Philippines (which was not classified as a Tiger) were also placed under pressure.
Figure 1 shows the exchange rates of various currencies against the US Dollar between 1989 and 2007. The stability of the Thai baht (shown in green) is obvious in the years prior to the slump. While the other currencies did fluctuate, and often in a downwards direction (with a trajectory of devaluation most obvious in the case of Indonesia (shown in red), in general, the pattern of change is common for currency exchange rates. The sharp decline in currency valuations in 1997 is obvious from this figure.
The figure does not depict the currencies of north Asia, the Indian subcontinent which were also deeply affected by the crisis. Enormous pressure was placed on the Hong Kong dollar, for example, which was also at that time pegged to the dollar (Stevens). The Indian rupee also devalued sharply. Devaluation occurred as foreign investors, who had previously seen the Tiger economies as an attractive and stable location for their investment funds, began to ditch the Asian currencies. The pressure on each of these currencies showed signs of contagion, with currency after currency impacted by the crisis.
Figure 1: Selected Asian Exchange Rates against the US Dollar, 1989 to 2007
The currency crisis was just the beginning of the problem for Asian financial crisis. It also caused a deeper crisis which was linked to the foreign exposure and government debt caused by the previous decade of rapid growth that had been experienced across the region (Kindelberger and Aliber 77).
Figure 2: Total Short-Term Debt to Foreign Exchange Reserves (Percent), Select Asian Economies, 1993 to 2007
Source: BIS 77
The pressure that was placed upon the financial sector has shifted to the banking sector across Asia, even after the announcements had been made, which would indicate support for the Thai currency(Stevens). During the growing years, both private firms and governments across Asia had built a high level of external debt. For example, in the four largest Association of South East Asian Nation (ASEAN) economies (Thailand, South Korea, Indonesia, and Malaysia), the ratio of foreign debt to GDP rose from 100 percent to 167 percent (Kindleberger and Aliber 78) (see figure 2). Large debt to GDP ratios was inevitable to give capital inflows, especially from the developed world. Investors from those regions were seeking better rates of return on their investment than they could have obtained had they invested in the more sluggish economies of the West. However, the currency devaluations that occurred in July 1997 and beyond meant that the repayments on these debts became more expensive, and in the long-term, unsustainable (Corsetti et al. 307-308). As a result, both private firms and governments began to default on their debts.
The International Monetary Fund (IMF) has a remit to maintain the stability of the global financial system, so it quickly took steps to try to contain and address the crisis (Stevens). The IMF insisted that the countries benefitting from a bailout should enact policies targeting fiscal constraint (Corsetti et al. 307-308). For example, government spending had to be cut, taxes increased, interest rates increased, and nationally held industries transferred to the private sector. Many commentators believe that the actions of the IMF prolonged the crisis and the recession that followed (BIS 77). Investors did not have confidence in the changes, with the high-interest rates seen as unsustainable, and capital flight increased. Overall, the Asian Financial Crisis could be seen as a containable problem, but it spilled over into a regional and far-reaching crisis because of market sentiment, as well as the actions of governments spurred on by the International Monetary Fund.
The Global Financial Crisis of 2007-2008 had some of the same characteristics as the Asian Financial Crisis, but the problem did not start in the currency markets. Mishkin (50) has identified several phases in the trajectory of the global financial crisis, beginning in around 2000, but there are long-term structural causes which can be traced as far as the 1980s, according to Crotty (563-580).
In the United States, and other countries in the West (especially in the United Kingdom and Europe), the deregulation of the financial services market has occurred since the 1980s. Prior to the 1970s, strict controls were levied on various financial institutions. For example, there were clear delineations between different types of financial institutions (such as lending banks and merchant banks) and these were not allowed to engage in activity in different financial markets (Crotty 563-570). Equally, financial institutions were not able to engage in activity across geographical boundaries. However, following Keynesian thought, which influenced the governments of the US, the UK and elsewhere from the 1980s onwards, these restrictions were lifted, enabling financial institutions to engage in commerce across a wider range of commercial activities and geographical territories.
This deregulation had implications for the financial activities of banks and other corporate entities (Mishkin 50). For example, restrictions were lifted over the ratio of capital to cash that banks were required to hold, and the proportion of investors’ deposits that could be offered on the market as loans. Mishkin (50-53) pays particular attention to the liberalization of credit that followed deregulation, and which became evident at the beginning of the 21st century. The deregulation of the banking sector can essentially be thought of as giving rise to the investment banking sector which now had multiple sources of funds (both in market and geographical terms). This in turn led to a liberalization in the level of credit made available to consumers in the form of personal loans, and especially mortgages (Mishkin 50), the broad supply of such funds led to dramatically lowered interest rates in consumer markets, but also lead to changes in interest rate spreads between riskier and relatively less risky financial instruments, especially in the US (see figure 3).
Figure 3: Interest Rate/Credit Spreads, 2000 to 2009, United States
Source: Mishkin (51)
In a self-reinforcing effect, these low-interest rates, underpinned by an increased supply of credit-fuelled an unprecedented increase in the values of property (Reinhart and Rogoff 340). Since the property sector was so lucrative too, credit lenders they were motivated to further increase the funds available to lenders. A fundamental aspect of the crisis was the growth of the subprime mortgage market (Mishkin 49-52). Sub-prime simply means ‘below average’, and these mortgages were offered to consumers with few guarantees that the borrowers would be able to repay the loans. Although Mishkin fails to account for it, the proliferation of the subprime mortgage market can be directly attributable to the liberalization of credit that had been occurring over the previous two decades.
Although sub-prime lending was lucrative, it also brought a high risk. If there was a rise in interest rates, defaults would occur, which would precipitate illiquidity in the financial markets. In fact, that is what occurred in 2007, when several high profile banks and financial institutions, like the Lehman Brothers, but also many other major commercial corporations, suddenly found that they did not have sufficient capital to sustain their operations and meet their own repayment obligations. Just as in Asia a decade earlier, the banks began to default.
Figure 5: Bank Lending, Global Financial Crisis, 2007 to 2009
Source: Mishkin (58)
A characteristic of the Global Financial Crisis that was similar to the Asian counterpart is a contagion, but that contagion occurred on a wider scale. While the crisis in the Asian currency markets spread to the major economies in that region, the financial crisis of 2007 to 2008 quickly spread quickly across major global markets (Blinder and Zindl 2). For example, figure 4 shows how the crisis impacted major economies in the European region.
Figure 4: Euro Area Sovereign 10-Year Swap Spreads, 2007 to 2010
Source: Basurto, Caceres, and Guzzo (4).
Here is a question that why this occurred in 2007 but not in 1997. One answer is that globalization and the interconnected of the financial markets was deeper in 2007 than it had been in 1997. This facilitated the rapid transmission of financial difficulties. However, while the IMF took a role to save the 1997 crisis, calling for coordinated fiscal action across the affected economies, there was a lack of coordination in the response of economies to the Global Financial Crisis. In the United States, for instance, the Federal Reserve Bank (FRB) took a number of steps to try to alleviate the problem and to bring the panic to an end (Blinder and Zindl 2). In the Eurozone, the action was led by the European Central Bank (ECB) and the European Union (EU) but implemented by sovereign governments Basurto, Caceres, and Guzzo (4).
Another interesting question is why the global financial crisis did not spread to Asian markets in 2007 and 2008. It’s no doubt that the focus of the media interest in the Global Financial Crisis in 2007 and 2008 was the European and US markets, which suggests that the Asian market was relatively protected from the downturn. However, contests that argument, Swee Keat (267-268) suggested that this was far from the case actually. According to Swee Keat, “the unexpected speed and force of the global financial crisis affected Asian economies through both the trade and financial channels, reflecting the region’s deep economic integration with the rest of the world. This effectively put to rest earlier notions that Asia had become “decoupled” from developments in the US” (267).
Since the Asian economies had been and were continuing to grow through export orientation, which gave them a connection to the developed markets of the West, it was inevitable that they would be impacted by the global financial crisis. With capital restricted in their key export markets, the value of Asian exports dropped sharply by over 30 percent (Swee Keat 267). In addition, five key Asian economies saw average credit default swap (CDS) spreads more than triple, stock prices in the market fell by more than 60 percent, and the exchange rates, which had only recently seen a recovery, came under pressure. Swee Keat goes on to claim that “Asian economies, excluding China and Japan, contracted by an average of about 6 2 percent from peak to trough in the current downturn. This is not far from the 8 3 percent gross domestic product (GDP) contraction during the Asian financial crisis, although Asia was not at the center of the present crisis” (267).
Thirdly, about the Policy responses and impact. Since these crises, governments and other policymakers have taken steps to prevent a future financial crisis from occurring with varying degrees of success. First, across Asia, currencies are allowed to float, enabling currencies to respond more rapidly to changes in the external environment, and preventing the overvaluation of currencies. Second, there have been a series of legislative actions designed to regulate the activities of key stakeholders in the crisis, such as investment banks and other financial institutions, and to prevent these corporations from engaging in risky behavior such as increasing debt ratios to unsustainable levels or proffering loans without sufficient deposits to back this up.
In the United States, for instance, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in the United States in 2010 and applies to any global investment body that operates within the US geographical boundary (Liaw 50). The Dodd-Frank Act establishes the principle that no bank is too big to fail and attempts to prevent banks from attempting to move risky products from the market to market. This assists with the regulation of their activities by policymakers. The incorporation of the Volcker Rule also prevents investment banks from undertaking proprietary trading (Liaw, 2012).
Outside of the US, it is the Basel III regulation or the Third Basel Accord, which has exerted the greatest impact on the activities of financial institutions and other stakeholders in the crises. The Accord, which was signed by representatives from 27 North American, European, Australasian, and Middle Eastern economies in 2010, is designed to regulate the activities of global banks with regards to their liquidity and capital holdings (Liew 48). By imposing minimum requirements on the amount of capital that banks are required to hold, it is argued that the ability of the financial services sector to cope with economic and financial pressures is bolstered.
Individual nations have also tried to take action the United Kingdom, for instance, the government introduced an annual tax levy imposed not on the revenues or profits of corporations, but on the level of debt held, which is designed to reduce the incentive of banks to hold debt (Leiw 56). In Greece, fiscal measures have been implemented as part of that country’s bailout by international organizations. Similar measures have been imposed in areas such as Spain and Portugal.
Regardless of these actions, in a cyclical, capitalist system, there is no guarantee that a financial crisis will not reoccur again in the future. Furthermore, any future crisis may have even deeper impacts than ever before, because the interconnectedness of the world’s economies is far from abating: it is growing. While regulations are now imposed on investment banks and other stakeholders in the financial services markets, the underlying economic activities that are shared in the financial crises considered here – the movement of capital across international markets, the tendency for key institutions to hold debt, the appeal of foreign markets for investors looking to reap financial rewards, and the exposure of international currencies to capital movements – remain unchanged. For these reasons, one should not expect that the environment for a financial crisis has disappeared.
Drawing on two of the most prominent examples from modern history, this paper has examined financial crises, exploring the reasons for their occurrence, their manifestations, and their consequences for economies and for society. Furthermore, the paper has examined the policy responses of governments and other pertinent authorities to the crises and has discussed strategies for mitigating and responding to them.
Based on the analysis that has been undertaken above, the following conclusions can be reached. First, while commentators such as Eichengreen and Portes are correct in that there are some shared characteristics of financial crises, as shown by the examples of the Asian Financial Crisis and the Global Financial Crisis, the short-term precipitators of crises can be very different. In the case of the Asian Financial Crisis, the problem began in the currency markets but was also driven by the strong (and unusual) period of growth that the Asian Tigers had experienced I the previous decade. The Global Financial Crisis, on the other hand, began not in the currency markets, but in the investment/credit markets, and can especially be attributed to the subprime mortgage market.
At the same time, however, both crises could potentially have been predicted. As noted by critics such as Crotty, the deregulation of the global financial markets (especially in the United States and Europe) took place over a period of decades, and the impact of the liberalization of credit it created in the financial markets could have been predicted and corrected for. Capital flight from devalued currency markets is also far from novel, and the high debt to GDP ratios that immediately preceded the Asian Financial Crisis was also a marker of things to come.
Finally, the paper has reached the conclusion that
efforts to avert future crises taken by sovereign governments and international
organizations alike are unlikely to have the impact of averting future crises.
The problem is that the system itself, the capitalist system, is susceptible to
boom and bust, and these problems are exacerbated by a globalized and highly
connected set of economies and markets.
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