4 Different Types of Financial Crises (Banking, Speculative Bubbles, International, Wider Economic Crisis)

2. Speculative bubbles and crashes:

A financial asset like stock shows a bubble when its price exceeds the present value of the future income (such as interest or dividends) that would be received by owning it to maturity. If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present.

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If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset’s price actually equals its fundamental value, so it is hard to detect bubbles reliably.

Well-known examples of bubbles and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000-2001, and the now-deflating United States housing bubble, known as sub- prime crisis.

3. International financial crises:

When a country maintains a fixed exchange rate and is suddenly forced to devalue its currency because of a speculative attack, this is called a currency crisis or balance of payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign default.

While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight.

Several currencies, part of the European Exchange Rate Mechanism suffered crises in 1992-93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asian Crisis during 1997-98. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.

4. Wider economic crises:

Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation.

Since these phenomena affect much more than the financial system, they are not usually considered financial crises per se. But some economists have argued that many recessions have been caused in large part by financial crises.

One important example is the Great Depression, which was preceded in many countries by bank runs and stock market crashes. The subprime mortgage crisis and the bursting of other real estate bubbles around the world have led to recession in the U.S. and a number of other countries in late 2008 and 2009.