Question

Explain the concept of an international financial crisis give either a real or hypothetical example

Answer 1

There have been many international crises over some last decades in the world. All these crises are good case studies to understand financial crises. Basically, a financial crisis starts with some kind of disruption in financial market (like asset price bubble, over-levaraging) and the disturbance go all the way to real markets (goods market) bringing down the whole system. Example of financial crisis are: Latin American crisis of 1982, Asian Financial crisis (AFC) of 1997, Global Financial crisis (GFC) of 2008 etc. Financial crises can be catogorised differently as per the cause and origin of the crisis.

The GFC is the most notable because of the magnitude and its international spread. So, let's understand this.

For political and as well as economic reasons, US government encouraged high consumption led by high borrowings. Interest rate were kept low by the federal bank. From the consumers side it meant that the cost of borrowing was low so people got cheap loans from banks (say to buy car or house or anything). From the investors side it meant that the returns on government borrowings were very low (because of low interest rate) so they looked for other assets with higher returns.

Now, on the consumers side, easy money made its way to real market via real estate i.e. cheap loans (and also the help of some housing agencies) enabled consumers to buy a house financed by these loans. Banks were reckless in lending big amount of money as they either underestimated or miscalculated the risks. Years (starting from early 2000s to till 2005-006) of easy financing increased demand for houses and house prices were at all time high. People who had borrowed from banks to buy these houses gained from the high prices as their collateral value increased.

On investors side, real estate was a good bet because the returns were higher than any other asset market. So big investments banks had invested huge amount of money in housing market and other government housing agencies.

So basically, everyone gained from the easy money as long as the property prices were high. Inverstors were happy because they got high returns, consumers were happy because they got houses on cheap loans and government was happy too as the economy was doing good.

The critical point comes when the house prices start to correct itself. As the loans of the banks matured and people defaulted on their payments, it was realised that not everything is right. Property prices started to come down, people started to loose their collateral value, banks were loosing on their loan repayments, investors were loosing the returns, and this whole cycle re-inforced itself and went on and on till the whole banking sytem collapsed. Big investments firms lost huge money as property prices collapsed and as a result many had to shut down their businesses. This collapse was not just restricted to US because there were many foreign investors also who had invested assuming the prices will only go up. At the end, government intervened by bailing out the banking system.

Note that GFC is just one manifestation of financial crises. The origin of disturbance in the financial market can be anything from correction of market prices to investors sentiments. This way, each financial crisis is a different case study and hence should not be generalised.