Dynamics of Financial Crises

10 Key excerpts on "Dynamics of Financial Crises"

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  eBook - ePub

  Understanding Financial Stability

  • Indranarain Ramlall(Author)
  • 2018(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  Chapter 6

  Financial Crises

  6.1. Key Features of A Crisis

  • Economic and financial crises tend to be recurrent in nature. This implies that the same phenomena are at work to constitute the genesis of a crisis.
  • Nearly, all crises exhibit three common elements. First, there is distrust in the financial system or lack of confidence in the financial system. Second, there are spillover or contagion effects such as in the case of Allen and Gale (2009) who base themselves on the contagious transmission of bank difficulties. Third, there are network effects based on endogenous interactions among different financial institutions.
  • A crisis is usually financial in first stage to then entangle the real economy in the second stage. This can be corroborated by the evolution of the global financial crisis in 2007 into an economic crisis and thereafter into a debt crisis.
  • Crisis often occurs because market players assume that EMH (all relevant information is automatically reflected in the price) holds while in practice it is hard to see that assets are properly priced – a clear instance of this appears during the US subprime crisis.
  • Humans have a strong tendency to herd so that deleveraging of assets often witnesses a highly painful adjustment in the financial system, all geared towards an unending downward spiral in asset prices.
  • Crises are often caused by two events, a euphoria phase and a de-illusion stage. Under the euphoria stage, there are strong incentives to push forward asset prices while in the de-illusion stage, investors began to realise of over-valued assets which then lead to massive sell-offs and drastic asset price declines. The leverage cycle (Geneakopolous, 2009) contributes to higher asset prices. When the de-illusion stage manifested in the case of the US subprime crisis, it led to negative equity holdings by borrowers who had no choice but to deliberately default on their home loans.
  • Political forces can also contribute to crises. For instance, in the case of the US subprime crisis, there were strong political incentives to make each household own his home.

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  Macroeconomics and Development

  • Mario Damill, Martín Rapetti, Guillermo Rozenwurcel(Authors)
  • 2016(Publication Date)
  • Columbia University Press

    (Publisher)

  A key motivation for the analysis is the question of “perverse” interactions among financial disequilibria, macroeconomic imbalances, and the stabil-ity of economic institutions, all of which are typical during crises. These interactions delay the return to normality and, under certain conditions, may even induce irreversible changes. On the financial side, we frequently observe permanent reversions in the process of financial development, whereas on the real side, the probability that the economy is mired in a low-growth trap or long-lasting period of recession increases, as was the case of the “lost decade” in Latin America in the 1980s and Japan in the 1990s. The analysis basically refers to emerging economies, but some aspects are also relevant to advanced countries. Traditionally, financial analyses tended to focus on the study of effi-ciency and equilibrium. As a consequence, too little effort was invested in the specification and description of the economic institutions that support market transactions. This made it difficult to analyze systemic instability and conflicts over property rights—phenomena that usually accompany financial crises. The lack of specification of the institutional framework creates a gap between microeconomics and macroeconomics and, in the case of the analysis of crises, makes it necessary to establish sounder macrofoundations for microeconomics (Fanelli and Frenkel 1995; Fanelli 2011). The approach to these issues has changed substantially in the last two decades thanks to the contributions of institutional analysis and the political economy literature. Institutional economics allows us to define C H A P T E R 1 4 Financial Crises, Institutions, and the Macroeconomy José María Fanelli 288 FINANCE AND CRISES the notion of economic systems more precisely, facilitating the study of disequilibria that originate from systemic failures.

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  International Development

  Issues and Challenges

  • Damien Kingsbury, John McKay, Janet Hunt(Authors)
  • 2016(Publication Date)
  • Red Globe Press

    (Publisher)

  Similarly, the influence of key alliances between the business sector, networks of think tanks and practising neoclassical economists have lost little of their influence. In this chap-ter I review some of the new thinking that has emerged on the nature and causes of economic crises, but also seek to understand why these new ideas have so far not been able to dislodge neoliberalism from its dominant position. However, on a more positive note, I ask whether the discipline of development economics, which as we also saw earlier Continuing Crises 109 was side-lined by the universalizing position of neoliberalism, may in fact now be given new life resulting from a more strident rejection of neoliberalism in the developing world. Global and regional crises in historical context: learning the lessons The renewed interest in the longer-term historical evidence on crises at the global level and in various countries and regions is not just about learning the lessons of previous crises to avoid or at least minimize the impact of new ones, important as this is. Far from being isolated, such events can be seen as causally related: each crisis sheds yet more light on the structure and dynamics of the global system of development, illustrating how the various parts of the whole are related and interact with each other, and how the resolution of each new event helps set the scene for the next convulsion. Paul Krugman ( 2008 ) has called this kind of study depression economics , a field that many misguided economists thought had been long consigned to the footnotes of economic history. Seen from this perspective, the Asian financial crisis of 1997–8 was not just an event confined to one region as the result of local errors but essentially one of the harbingers of the GFC, a theme to which we will return later in this chapter.

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  The Economic Dynamics of Law

  • David M. Driesen(Author)
  • 2012(Publication Date)
  • Cambridge University Press

    (Publisher)

  4 The Economic Dynamic Theory The economic dynamic theory requires a focus on the shape of change over time. Its chief normative goal involves the avoidance of systemic risk without shutting down important opportunities for economic development. Finally, it employs economic dynamic analysis in order to identify systemic risks and proposals to avoid them or meet other legal goals. Accordingly, an economic dynamic approach implicates law’s focus, goals, and methods; this chapter takes up each of these elements in turn. It then addresses a possible concern about the theory: the question of how this theory addresses the collateral negative consequences of measures chosen to avoid systemic risks. It closes by describing how widely recognized economic tools can aid economic dynamic analysis. focus on the shape of change over time In Chapter 3 we saw that policymakers confronting a major financial crisis focused on the likely future direction of change over time – straight down. They saw their task not as achieving some perfect equilibrium or providing an ideal allocation of resources, but as changing the direction the economic dynamics pushed toward by stabilizing the economy to prevent a downward turn from metastasizing into a broad economic collapse. This focus on the direction of change over time, though underappreciated, plays a fundamental role in our law, and not only in moments of such obvious crisis. Lawmakers create new law because they recognize that a serious problem requires a remedy. This often means that they see society headed down a self- destructive path and pass legislation or take other action to change that path’s direction. Lawmakers sometimes seek to provide new opportunities as well. But often those goals merge. Avoiding future dangers opens up space to seize opportunities. 50

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  Macroeconomics in Emerging Markets

  • Peter J. Montiel(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  A crisis occurs when much or all bank capital is exhausted. Source: Kroszner et al. (2007). review questions 1. Why are bank regulation and supervision often unable to prevent the emergence of banking crises? 2. Do banking crises tend to be caused by “bad policy, bad banking, or bad luck” (the phrase is from Caprio and Klingebiel (1997, page 79))? Explain. 3. What are some possible macroeconomic roots of banking crises? 4. Describe the channels of transmission through which banking crises can affect the real economy. 5. Why do banking crises tend to result in large increases in public-sector debt? exercises 1. Why are the fiscal costs of banking crises (the cost to the government of making bank depositors whole) not an appropriate measure of their true social costs? 2. Explain why empirical studies of the determinants of banking crises have some-times found that the likelihood of such crises is increased by the presence of deposit insurance. 648 Varieties of Emerging-Market Crises 3. Some commentators have suggested that to assist regulators in doing their jobs, banks should be required to hold some fraction of their portfolios in the form of the subordinated debt of other banks (these are securities that, in the event of bank liquidation, are paid after other bank creditors are paid, but before bank owners). How would this requirement help bank regulators? 4. Assume that the residents of a country hold no debt denominated in foreign exchange. How would the real effects of a banking crisis in that country be affected by whether the country maintains a fixed or a floating exchange rate? 5. What would you expect to happen to the balance sheet of the central bank of a country that is experiencing a banking crisis? Explain why. references and further reading Balino, Tomas, and V. Sundararajan (1991), Banking Crises: Cases and Issues , Washington, DC: International Monetary Fund.

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  How Latin America Weathered the Global Financial Crisis

  • José De Gregorio(Author)
  • 2013(Publication Date)
  • Peterson Institute for International Economics

    (Publisher)

  71 4 Financial Stability Financial systems are essential to development, but they can also be a source of disaster and therefore a source of policy confusion and ambivalence. A well-functioning financial system is key to prosperity. It promotes eco-nomic growth by channeling investment funds from savers to borrowers (Levine 2006), and it is central to promoting entrepreneurship and facilitating invest-ment, including human capital accumulation. Meanwhile, it provides house-holds with financing in order to smooth consumption, with insurance, and with safe and cheap means of payment. The difficulties faced by households and firms in many emerging-market economies because of underdeveloped fi-nancial institutions and markets should be a clear reminder of this positive role. But financial deepness may also be a source of big problems. As in many situations, more is not always better, especially when more comes at the cost of excessive risk. When a recession or a currency crisis comes together with a finan-cial crisis, its output costs increase significantly (Reinhart and Rogoff 2009). In the past in Latin America and Asia, currency crises had output costs of 7 percent of GDP over a five-year period, and when crises come with a banking crisis the costs double (De Gregorio and Lee 2004). Therefore, a strong financial system and a flexible exchange rate regime can be very effective in mitigating the cost of a crisis. Finally, unfettered financial markets are prone to deep crises, but regulation has its limitations and may even be a source of problems because of negligence, political capture, and other agency problems. Crises are not always avoidable, so it is also key to have appropriate resolution mechanisms to con-tain the costs of financial instability and quickly restore normalcy. This chapter focuses on the policies that could prevent these problems and on the evidence of financial market resilience in Latin America.

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  Financial Dynamics and Business Cycles

  New Perspectives

  • Willi Semmler(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  In sum, a number of central themes of the dynamics with money and finance and their implications for macrofluctuations and economic policy are presented, and the empirical measures and trends of debt financing are provided. It may be appropriate, however, to indicate a further research strategy that could not be pursued here fully. The fol lowing additional dimensions could be explored on these topics: (1) microeconomic studies of borrowing and investment behavior of firms and their effects in a system of interdependent dynamics; (2) empirical and theoretical studies of debt financing of firms and macrofluctuations in open economies; (3) an intercountry comparison of stylized facts concerning the evo-lution of the financing structure of firms, debt burden, and debt payment commit-ments and their impact on macrofragility; (4) major policy implications for extended versions of such models (e.g., to open economies). Subsequent research on dynamical methodology, extended models, stylized facts and trends, and policy implications will help to introduce further theoretical, empirical, and policy dimensions into the theme ''Financial Dynamics and Business Cycles.'' The contributions to this book should be considered an important advance in this development. Notes 1. The conference and the publication of its papers were made possible by a generous grant from Manufacturers Hanover Trust, which bears no responsibility for any views expressed in this volume. The organizers also appreciate very much the help and assistance of Marsha Lasker and Karin Ray. 2. Foley's paper was originally presented at the conference but has been published elsewhere in the meantime. INTRODUCTION xix Selected Bibliography Barro, R. J. 1984. Macroeconomics. New York: John Wiley. Benassy, J. P. 1984. A Non-Walrasian Model of the Business Cycle. Journal of Eco-nomic Behavior and Organization 5:77-89.

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  Explaining Financial Crises : A Cyclical Approach (Volume 53.0)

  • Marc Peter Radke(Author)
  • 2018(Publication Date)
  • Peter Lang International Academic Publishers

    (Publisher)

  perhaps a foreign banking crisis, a currency crisis (generating a twin crisis), and by a large contraction in the real sector. Regarding systemic financial crises, the initial fall in expectations and the resulting decline in asset prices causes collateral values to drop sharply, initiating a large rise in domestic and international interest rates due to increasing default risk. Liquidity problems then emerge on the one hand through rising debt costs, and on the other hand by a sharp fall in earnings caused by a drop in aggregate demand. In order to meet due payment obligations business firms, as well as banks have to engage in widespread fire-sales of assets since liquidity in capital markets has dried up, and rolling over or increasing debt becomes impossible. Domestic and foreign financial institutions incur losses by an increasing amount of non-performing loans, causing a widespread domestic banking crisis and also failures among foreign financial institutions. Foreign investors start to withdraw their funds which are in most cases short-term, causing further liquidity needs in foreign currency for business firms and for banks, resulting in further fire-sales of assets since foreign exchange reserves cannot be obtained by debt-finance. Owing to large current account deficits having been financed by capital inflows during the boom phase, central banks face a liquidity problem in foreign currency since the stock of existing reserves falls short of the stock of foreign claims. In order to cope with large capital outflows and a limited stock of foreign reserves, central banks generally have the choice between two alternatives which are both bad alike. In order to prevent a deval-uation by reducing further capital outflows, central banks have to pursue contractionary monetary policy, leading to high domestic interest rates to compensate investors for in-creasing default risk.

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  International Trade in East Asia

  • Takatoshi Ito, Andrew K. Rose, Takatoshi Ito, Andrew K. Rose(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  Kaminsky, Graciela L., and Carmen M. Reinhart. 1999. The twin crises: The causes of banking and balance-of-payments problems. American Economic Re-view 89:473–500. Krugman, Paul. 1979. A model of balance of payments crises. Journal of Money, Credit and Banking 11:311–25. Masson, Paul. 1998. Contagion: Monsoonal e ff ects, spillovers, and jumps between multiple equilibria. International Monetary Fund Working Paper no. WP/98/ 142. Washington, DC: IMF, September. Mendoza, Enrique G. 2001. Credit, prices, and crashes: Business cycles with a sud-den stop. NBER Working Paper no. 8338. Cambridge, MA: National Bureau of Economic Research, June. Obstfeld, Maurice. 1996. Models of currency crises with self-fulfilling features. Eu-ropean Economic Review 40:1037–47. Comment Chin Hee Hahn It has been recognized in the previous literature that financial crises have a “contagious e ff ect.” While the focus of several preceding studies was on whether trade linkage plays a role in transmitting crises across countries, this paper examines more closely how financial crises a ff ect exports and imports. Insofar as understanding the e ff ects of financial crises on trade flows is complementary to understanding the role of trade in transmitting crises, this paper raises a very important question. To address this ques-tion, this paper provides an outline of the theoretical framework as well as an empirical analysis. I think this paper is a serious attempt to add to the literature on the e ff ects and transmission of financial crises. Nevertheless, the specification of the regressions doesn’t seem to allow us to interpret the empirical results clearly. Because the basic regression model includes gross domestic product (GDP) and devaluation variables, the estimated coe ffi cients on crisis dummy variables and, hence, the im-pulse responses of trade flows to crises would capture the e ff ect of crises on trade that is not captured by changes in the GDP or the exchange rate.

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  Financial Assets, Debt and Liquidity Crises

  A Keynesian Approach

  • Matthieu Charpe, Carl Chiarella, Peter Flaschel, Willi Semmler(Authors)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  85 86 Debt deflation and the descent into economic depression discussed in academic and policy circles. The need for a fundamental restructuring of the IMF and World Bank and a new financial architecture is continuously stressed based on the judgement that the world has, in the last decade, faced several severe financial challenges, with the latest being the biggest since the 1930s. Debt dynamics can be, as Reinhart and Rogoff (2009) have argued, a very destabilising force and therefore appear to be an important problem that the world economy may be facing. This issue was visibly exemplified in the recent financial market meltdown in 2007– 9. It began with the very large indebtedness in the US subprime (mortgage) market in 2007, evolved as a credit crisis through the US banking system in 2008/9, and subsequently spread worldwide, causing a worldwide financial panic, and staggering declines in global growth rates. This time, the usual boom-bust mechanism with the risen asset prices and a credit boom was reinforced by new financial innovations; specif- ically, the development of new financial intermediations through complex securities, such as mortgage-backed securities (MBS), CDO and credit default swaps (CDS). The complex securities, which were supposed to outsource and diversify idiosyncratic risk, have, jointly with the changes in the macroeconomic environment, actually acceler- ated risk taking and the boom, but also the bust. First through high asset prices and high leveraging and then, second, on the downside through the instability of credit via a credit crunch. These innovations provided the underlying financial intermediation mechanism through which the asset price boom and busts were fuelled. Although the actual way in which boom-bust cycles in asset prices and borrowing and lending evolve may change over time the mechanisms at work are very similar; for further details we refer the reader to Bernard and Semmler (2009).

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