What is financial crises and its impact on global financial market and in economy | Definition, causes and examples

Think of the world economy as a huge, busy metropolis where money moves like heavy traffic. Similar to a severe traffic gridlock, a financial crisis causes everything to come to a complete halt. A major bridge (a large bank or investment) collapsing or a rumor spreading like wildfire, sending everyone into a panic and forcing them to alter their plans, are just two of the many ways that these jams can begin. When this occurs, there may be severe repercussions as the money flow slows down or possibly stops. Everyone’s life may become more difficult as a result of businesses finding it difficult to obtain loans, job losses, and rising costs for necessities.

Definition of Financial Crisis

A financial crisis is a scenario where the value of financial institutions or assets, like money in banks or equities, declines very unexpectedly and severely. Imagine it as the “engine” of the economy failing. When this happens, people rush to get their money out of banks, businesses struggle to secure loans and may fail, and the value of investments plummets. Everyone finds it extremely difficult to manage their finances as a result of the broad economic problems brought on by this loss of confidence and worth, which includes job losses and a deep recession.

Causes of Financial Crises

• Asset Bubbles: When the prices of assets (such as stocks or homes) soar to unreasonably high levels due to speculation and excessive enthusiasm rather than their actual worth, this is known as an asset bubble. As soon as the bubble “bursts,” prices crash.
• Excessive Debt and Leverage: People, businesses, and even governments are put at risk when they take on excessive debt. A wave of defaults that harm lenders and devastate the economy results if they are unable to earn enough money to pay back their loans.
• Financial Innovation and Complexity: It can be difficult to comprehend the development of novel, intricate financial instruments, such as the mortgage-backed securities of the 2008 financial crisis. They frequently conceal the actual degree of risk, and when they collapse, the financial system as a whole suffers unpredictable consequences.
• Interconnectedness and Systemic Risk: Contemporary financial institutions are intricately intertwined. Because they are all owed money by one another, the failure of one large bank or fund might have a cascading effect, leading to the downfall of others. A common way to describe this is “too big to fail.”
• Financial Institution Mismanagement: Banks and other institutions may make reckless wagers, neglect to maintain adequate emergency funds, or engage in careless lending (e.g., offering mortgages to people who can’t afford them).
• Economic Shocks and Confidence Loss: A rapid, unforeseen occurrence, such as a significant company bankruptcy, a pandemic, or a sharp increase in oil costs, can cause confidence to be shaken. Panicked individuals and investors withdraw funds from banks and liquidate their holdings, exacerbating the crisis.
• Failures by Governments and Regulators: Occasionally, governments or regulators do not adequately monitor the financial sector. They might promote hazardous lending, maintain interest rates too low for an extended period of time, or fail to update regulations to handle emerging risk types, all of which would encourage risky behavior.

Examples of Financial Crises

The European Sovereign Debt Crisis (2010-2014)

• Cause: A number of Eurozone nations, most notably Greece, Ireland, Portugal, Spain, and Cyprus, accumulated unmanageable amounts of public debt. Their sluggish economic development and lack of fiscal restraint were made clear by the worldwide crisis of 2008.
• Impact: A decline in trust in European government bonds and banks, the need for large EU/IMF bailouts, and the imposition of strict austerity measures on the populace (tax hikes and budget cuts).

The Great Depression (1929-1939)

• Cause: The 1929 Wall Street Crash served as the catalyst. Because of speculative margin purchasing, a huge stock market bubble burst disastrously.
• Impact: A terrible global economic crisis that lasted for ten years, widespread bank failures, and crippling unemployment that reached 25% in the United States. As a result, numerous contemporary financial rules and safety nets were established.

The Dot-com Bubble (2000-2002)

• Cause: The stock values of early internet-based businesses, or “dot-coms,” experienced a large speculative bubble. Because of the excitement surrounding the new technology, investors poured money into companies that had no earnings or even viable business plans.
• Impact: The technology-heavy NASDAQ stock index lost more than 75% of its value when the bubble burst, which caused a large, albeit brief, recession and the demise of numerous dot-com enterprises.

The Global Financial Crisis (2007-2008)

• Cause: A “perfect storm” involving the housing market in the United States. Subprime mortgages were recklessly lent, packaged into intricate financial products (securities), and subsequently sold all over the world. The value of these assets plummeted when homeowners began to fail.
• Impact: The worst global recession since the Great Depression, the failure of large companies like Lehman Brothers, a halt in international credit, and significant bank bailouts by the government.

Impact on Global Financial Markets

Spillover into Commodity Markets

• Declining Demand: When the world economy slows down, there is a substantial decline in demand for raw commodities, such as industrial metals, copper, and oil, which drives down their prices.
• Gold as a Safe Haven: When trust in paper money and financial systems is low, gold is viewed as a conventional, tangible store of value, which is why its price frequently rises during crises.

Breakdown of Correlations and Contagion

• Contagion: When a crisis begins in one nation or asset class, it can swiftly spread to markets that don’t seem to be connected. For instance, European banks that held these toxic assets were quickly impacted by the 2008 U.S. subprime mortgage crisis.
• Correlation Breakdown: Typical connections between various asset classes may no longer hold true. With the exception of the safest government bonds, practically everything may be sold off at once during a panic.

Credit Crunch and Liquidity Freeze

• Lending Halts: Banks and other financial institutions become very hesitant to lend to one another, businesses, and individuals because they are afraid of losing money and are unsure of who is solvent.
• The market where banks lend to each other on a short-term basis, which is essential for day-to-day operations, freezes up during an interbank market seizure. The financial system suffers from a severe cash shortage as a result.

Extreme Volatility and Plummeting Asset Prices

• Stock Markets: Global equity markets frequently undergo abrupt and severe drops. Major stock indices (such as the S&P 500, FTSE, and Nikkei) crash as a result of investor panic that triggers enormous sell-offs.
• Bond Markets: First, there is a “flight to safety,” in which investors purchase government bonds (such as German Bunds or U.S. Treasuries) and sell riskier assets. As a result, their yields decrease and their prices increase. However, default fears cause the value of corporate or crisis-ridden country bonds to drop.

Loss of Confidence and “Flight to Quality”

• This serves as the main motif. Trust, the essential component of any financial market, vanishes. Investors become less confident in the safety of the system, banks’ solvency, and the worth of intricate financial instruments.
• This causes a “flight to quality” or “flight to safety,” in which money is transferred from all risky investments (e.g., stocks, corporate bonds, emerging markets) to the safest assets (cash and government bonds with the highest ratings).

Currency Instability and Forex Turbulence

• Safe-Haven Flows: Investors rush to shift their funds into “safe” currencies like the Japanese yen, Swiss franc, and US dollar. As a result, these currencies see a significant increase in value.
• Emerging Market Sell-Off: On the other hand, investors withdraw funds from riskier emerging economies, which results in a sharp decline in the value of those markets’ currencies. These nations may be unable to pay back their foreign debt as a result.

Impact on the Economy

Fall in Asset Values and Wealth Destruction

• Major assets that people depend on for their wealth see a sharp decline in value.
  • Housing Market: When home values plummet, homeowners may have “negative equity”—that is, more debt than their home is worth.
  • Stock Market: Investment portfolios and retirement funds, such as 401(k)s, drastically depreciate.
  • This “wealth effect” exacerbates the recession by making people feel poorer and less likely to spend.

Credit Crunch for Businesses and Consumers

• The financial markets’ “lending freeze” has an immediate impact on Main Street.
  • Bankruptcies and a lack of innovation result from businesses’ inability to obtain loans for expansion, inventory purchases, or simply payroll.
  • Customers reduce their significant purchases as a result of finding it more difficult to get credit cards, auto loans, or mortgages.

Deep Recession or Economic Contraction

• The most obvious effect is a considerable drop in a nation’s productivity. The overall economy contracts as investment and spending decline, resulting in a recession that is frequently more severe and lasts longer than a normal downturn.

Surge in Unemployment

• One of the most agonizing outcomes for regular people is this. Businesses are compelled to reduce expenses as they encounter losses, lose access to finance, and witness a decline in the market for their goods. This results in:
  • Mass Layoffs: Numerous industries experience widespread employment losses.
  • Hiring Freezes: Businesses cease taking on new hires.
  • Growing Underemployment: People who require full-time jobs are compelled to work part-time.

Decline in Consumer and Business Confidence

• Confidence is destroyed by the crisis’s fear and uncertainty.
  • Fearful of losing their employment, consumers cut back on non-essential spending and save more money, which further lowers demand for goods and services.
  • Because the future is uncertain, businesses put off investing in new factories, equipment, and research.

Social and Political Consequences

• Political instability, heightened poverty, and social unrest are frequently the results of economic hardship. Protests, an increase in populist politics, and a decline in trust in governmental and financial institutions might result from public outrage over bank bailouts and job losses.

Increased Government Debt and Austerity

• Massive government intervention is required to save the economy. They:
  • Save important industries and failing banks.
  • Spend more on social safety nets, such as unemployment insurance.
  • Reduce taxes to encourage expenditure.
• The national debt rises precipitously as a result. Governments are frequently compelled to impose austerity measures, reducing infrastructure expenditure, pensions, and public services, in order to manage this debt, which can hinder economic recovery and increase the burden on taxpayers.

Conclusion

In summary, financial crises show how intertwined markets and institutions are, highlighting the precarious balance of the global economy. Navigating the intricacies of the contemporary financial world and promoting stability and resilience in the face of economic difficulties require an understanding of the origins, effects, and reactions to these events.

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