What is Financial CrisisTheterm financial crisisisappliedbroadlytoavarietyofsituationsinwhichsomefinancial assets suddenly lose a large part of their nominal value. In the 19th and early20thcenturies, manyfinancial criseswereassociatedwithbankingpanics, andmanyrecessionscoincidedwiththesepanics. thersituationsthat areoftencalledfinancialcrises include stock market crashes and the bursting of other financial bubbles, currencycrises, and sovereign defaults. !inancial crises directly result in a loss of paper wealth butdo not necessarily result in changes in the real economy."any economists have offered theories about how financial crises develop and how theycouldbeprevented. Thereisnoconsensus, however,andfinancial crisescontinuetooccur from time to time.Causes and consequences of financial crisisa. Strategic complementarities in financial marketsIt is often observed that successful investment re#uires each investor in a financial markettoguesswhatotherinvestorswilldo.$eorge%oroshascalledthisneedtoguesstheintentionsof others&refle'ivity&. %imilarly,(ohn"aynard)eynescomparedfinancialmarkets to a beauty contest game in which each participant tries to predict which modelotherparticipants will consider most beautiful. *ircularity and self+fulfilling propheciesmay be e'aggerated when reliable information is not available because of opa#uedisclosures or a lack of disclosure.b. LeverageLeverage, whichmeans borrowing tofinance investments, is fre#uently citedas acontributor to financial crises. ,hen a financial institution -or an individual. only investsits own money, it can, in the very worst case, lose its own money. /ut when it borrows inorder to invest more, it can potentially earn more from its investment, but it can also losemore than all it has. Therefore leverage magnifies the potential returns from investment,but also creates a risk of bankruptcy. %ince bankruptcy means that a firm fails to honor allits promised payments to other firms, it may spread financial troubles from one firm toanother.c. Asset-liability mismatch0notherfactorbelievedtocontributetofinancial crisesisasset-liabilitymismatch, asituationinwhichtherisks associatedwithaninstitution&s debts andassets arenotappropriately aligned. !or e'ample, commercial banks offer deposit accounts which canbe withdrawnat any time andthey use the proceeds tomake long+termloans tobusinesses and homeowners. The mismatch between the banks& short+term liabilities -itsdeposits. and its long+term assets -its loans. is seen as one of the reasonsbank runs occur-when depositors panic and decide to withdraw their funds more #uickly than the bankcan get back the proceeds of its loans.d. Uncertainty and herd behavior$overnments have attempted to eliminate or mitigate financial crises by regulating thefinancial sector. ne ma1or goal of regulation istransparency2 making institutions&financial situationspubliclyknownbyre#uiringregular reportingunderstandardi3edaccountingprocedures. 0nother goal of regulationis makingsure institutions havesufficient assets tomeet their contractual obligations, throughreserve re#uirements,capital re#uirements, and other limits on leverage.e. ContagionContagionreferstotheideathat financial crisesmayspreadfromoneinstitutiontoanother,aswhenabankrunspreadsfromafewbankstomanyothers, orfromonecountry to another, as when currency crises, sovereign defaults, or stock market crashesspread across countries. ,hen the failure of one particular financial institution threatensthe stability of many other institutions, this is called systemic riskf. Recessionary effects%ome financial crises have little effect outside of the financial sector, like the,all %treetcrash of 1945, but other crises are believed to have played a role in decreasing growth intherestoftheeconomy. Therearemanytheorieswhyafinancialcrisiscouldhavearecessionaryeffect onthe rest of the economy. These theoretical ideas include the&financial accelerator&, &flight to #uality& and &flight to li#uidity&, and the )iyotaki+"ooremodel. %ome &third generation& models of currency crises e'plore how currency crises andbanking crises together can cause recessions.Economic Crisis of 21st centurySummary in Years200062001 6 Turkish *rises2000 6 early 2000s recession2001 6 0rgentine *rises2001 6 /ursting of dot+com bubble 6 speculations concerning internet companies crashed2004+2011 + Icelandic financial crisis2005612 6 !inancial crisis of 200562012, including the 2010 7uropean sovereign debtcrisisEconomic Crisis of the Twenty-First CenturyThe collapse of the world economy and of the 0merican economy in the !all of 2004 wasthe most severe economic crisis since the $reat 8epression of the 1929+90s. Therewerebothsimilaritiesanddifferencesbetweenthetwo. /othoriginatedinthe:nited %tates and dramatically impacted the world economy. /oth were precipitated bycollapse of the leading sector of the :.%. economy; the stock market in the 1920s, and thehousing market in the 21st century. /oth occurred in economies where there were largemaldistributions of wealthbetweenrichandpoor. /othweredependent uponmassconsumption for the continuation of prosperity. /oth suffered the conse#uences of a lackof government regulation of economic practices and la' enforcement of e'istingregulation. /othwereaccompaniedbycorrupt practicesinthefinancialsectoroftheeconomy. In both instances, the attempt to use government action to introduce correctivemeasures was met with fierce resistance by political forces, which primarily representedwealthy, corporate, financial interests. Inbothcircumstancesthosepowerful interestsdominatedthepolitical systemandusedit fortheirownprivategoals. *onsiderthiscomparison 0 reasonable conclusion might be drawn that lessons of the past were ignored.There were, however, numerous differences. The 0merican economy of the 1920s wasconsiderably smaller than it was in the 2000s. The :nited %tates was the leading creditornation of the world in the 1920s with very little debt. In the 2000s, the :.%. had becometheleadingdebtornationoftheworld. This, inthe1920s, gavethe:nited%tatesanadvantageous position from which to respond to economic crises, whereas itsindebtedness in the 2000s made solutions more difficult. In the 1920s, the world economywas in an early stage of the fossil fuel era during which fossil fuel resources were tappedas theprimarysourceof power fuelingtheeconomy. Inthe1920s, theinstitutionsassociated with fossil fuels were growing rapidly with little resistance from establishedspecial interests. In the 2000s, the fossil fuel era was beginning to come to an end, butestablishedinterestsfoughtwitheverymeansavailableincludingwarfare, tomaintaintheir positions of power, wealth and influence. In the 1920s, the 0merican economy ledthe world and the :.%. government could act unilaterally to stimulate growth throughoutthe world. In the 2000s, the :.%. economy was still the single most influential economyintheworld, but it sharedresponsibilitywith*hina, whichhadbecomethelargestcreditor nation, and with 7urope.In the 1920s, the prevailing economic theory for dealing with economic collapse was thatthe laws determining the business cycle were immutable, and governments could do littleabout it.%ince then,)eynesian economic theorypostulatedthatgovernment orpublicspendingcanstimulate economicgrowthwhenthe private sector fails todoso. 0countervailing theory of the *hicago school of economics, which developed in the 1950s,claims that the private sector is the essential driver of economic growth. The government,throughta'ationandtoomuchregulation, becomes a dragonthe economy. Thesetheories are not necessarily mutually contradictory.8uring eras of prosperity, the private sector is the primary driver, while the public sectorpursues longtermob1ectives deemedtobeinthepublicinterest, at thesametime,improving and maintaining the infrastructure. 8uring such times, it is appropriate for thegovernment torunasmall annual surplus, paydowne'istingdebt, or accumulateareserve needed to meet an economic slowdown. 8uring recessionary eras, however, it isdesirablefor thegovernment tostimulatetheeconomybyspendingine'cessof itsincome, inother words, by deficit spending. Toachieve the proper balance underparticular circumstances is a challenge.7conomictheoryis always complicatedbypolitical realities.