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Financial Crisis: How And Why It Happens

Financial Crises: How and Why and Lessons

Recent Major Financial Crises

1980's: Debt crisis for developing countries (Latin America and Africa)

1992: European Exchange Rate Mechanism (especially UK and Sweden)

1994-95: Mexico (Tequila crisis) and Argentina

1997-98: Asian financial crisis (Thailand, Indonesia, Korea, Philippines, Malaysia)

1998: Russia

1999: Brazil

2000-02: Turkey

2001-02: Argentina (again)







Nature of Financial Crises

Exchange rate crises

Sudden, drastic depreciation of the country's currency

Banking crises

Depositors lose confidence (disintermediation)
Banks can't perform lending function

Effects

Severe recession, due to:
Collapse of bank loans
Reduction in consumer demand
Higher interest rates

Inflation, due to:
Higher import costs



Causes of Financial Crises:
1. Macroeconomic Imbalances

Where: Russia 1999, Brazil 1999, Turkey 2000, Argentina 2001

Characteristics of imbalances:

Causes of Macroeconomic Imbalances

High government spending (G) due to:

Public subsidies for businesses
Infrastructure spending
Lack of fiscal discipline

Insufficient tax revenues (T) due to:

Poorly developed tax systems
Lack of tax enforcement

Money supply (M) growth too high due to:

Lack of independence of central bank
Political pressure on central bank to accommodate fiscal deficits



Pressure on Exchange Rates

CA deficit and inflation cause pressure in forex markets on currency to depreciate.

Government does not want that due to:
Higher import costs
Loss of prestige

Government tries to keep currency from depreciating too fast:
By raising interest rates domestically
By using foreign reserves to buy its currency back

But this creates problems:
Higher interest rates slow the domestic economy
Loss of foreign reserves


Loss of Confidence

Foreigners stop lending

Speculators think the currency will depreciate...