© The Financial Times Ltd 2014 FT and 'Financial Times' are trademarks of The Financial Times Ltd.
A global financial crisis refers to a situation when, for reasons that may not necessarily grounded in accurate information or apparent logic, parties to financial contracts in many nations simultaneously conclude that the contracts they hold are unlikely be honoured by counterparties or that the financial assets that they hold are likely to be worth substantially less than previously thought.
As a result these parties, such as banks, typically cease to advance funds to others, demand early repayment of loans and other financial instruments, liquidate holdings of financial assets that can be sold, increase collateral requirements etc to a degree that is outside the prior expectations of market participants. The result is what is often referred to as “frozen” financial markets, where trading volumes fall considerably and parties often cannot be induced to trade financial instruments no matter what prices are offered.
Private individuals, fearing for their wealth, contribute to such crises by demanding that banks and other financial institutions repay as much as possible and typically seek to hold accepted stores of value, such as gold and cash. Meeting their customers’ demands causes banks and other financial institutions to call in their loans and to liquidate holdings of financial assets, further adding to the downward pressure on prices of financial assets, which in turn impairs the balance sheets of financial institutions.
Like national financial crises, once a global financial crisis gets under way in the absence of credible, verifiable information about the viability of financial institutions, fear – more generally, expectations – alone can accelerate the selling of financial assets, the collapse of asset prices, and ultimately, the freezing up of financial markets. It is for this reason that financial crises are often associated with much talk of the need to “restore confidence” in affected financial markets and institutions.
A wide range of financial assets can be subject to such simultaneous “loss of confidence” including stocks, government bonds, bank deposits, asset backed securities, and insurance contracts. It would be wrong, therefore, to associate global financial crises with deficiencies in any one type of financial counterparty, such as governments, or with sharp falls in the values of any one type of financial asset, such as stocks.
A global financial crisis can, but need not, result in a global economic crisis. In modern economies, where working capital is needed to tide firms over from the time when they incur costs for parts, supplies, and staff to the time when they receive revenues, the subsequent withdrawal of credit creates the potential for widespread corporate bankruptcies. A financial market breakdown, then, can quickly create a severe downturn in economic activity, involving falls in national income and increases in unemployment that are in excess of those witnessed during traditional economic recessions. That these dynamics can play out simultaneously in many jurisdictions implies that, left unchecked, a global financial crisis can result in a global economic crisis, an example of which is the Great Depression of the 1930s.
The transmission of the financial and economic shock from one nation to another is accelerated in an era of substantial cross-border flows of financial capital, goods, and services. These cross-border linkages further depress an economy suffering from a financial crisis.
There are four primary channels of so-called contagion, the first three of which are private sector driven.
First, losses on financial assets held abroad can trigger losses in confidence in the financial institutions at home that made those investments.
Second, financial market participants in one country may raise their assessment of certain adverse risks taking place there in the light of recent developments in other nations, reasoning that certain pertinent circumstances are common. An example is, in the aftermath of Thailand succumbing to a financial crisis in July 1997, asset prices and currencies in other southeast Asian nations were marked down in value because of perceived commonalities in institutional and governance structures. Whether such assessments were correct is immaterial.
That many firms supply customers abroad provides another means by which severe economic downturns can spread across borders, as falling exports reduce the national incomes. This trade-related channel has grown in importance with the development of international supply chains, where reductions in sales of a final good can produce cuts in orders for foreign sourced parts and components worth multiples of the original transaction. This has been referred to as the bullwhip effect and was thought to account for part of the sharp fall in global trade witnessed in 2009.
The fourth reason why financial and economic crises can spread across borders is because of government policies that seek to bolster the domestic economy at the expense of other nations. Such beggar-thy-neighbour policies include raising tariffs and other trade barriers, devaluing national currencies, insisting that domestic financial institutions repatriate financial asset holdings from abroad, restricting government contracts to domestic firms, subsidising exports so as to win contracts abroad at the expense of firms located in trading partners, and taxing foreign firms and workers worse than rival domestic firms, amongst others.
Even though a key feature of a global financial crisis is the simultaneous freezing up of some financial markets, cross-country differences in asset holdings, debts, and the business cycle, as well as differences in the speed with which shocks are transmitted from one nation to another imply that phases can often be discerned in any resulting global economic crisis.
Several phases can be identified in the Global Financial Crisis that took hold in September 2008, which is frequently attributed to the collapse of US investment bank, Lehman Brothers, although many other financial markets had begun to malfunction before that time. The recessions experienced in many economies and the growth slowdown that followed the Global Financial Crisis are often referred to as elements of the Great Recession.
Before Lehman Brothers collapsed, the effects of sharp revaluations in the prices of lower quality US mortgage-backed securities (often referred to as subprime mortgages) began to be felt in other countries (notably in Europe) from the third quarter of 2007, and is often associated with the first phase of recent global crisis.
In fact, it was only around the time of the collapse of Lehman Brothers, which ultimately the US government had refused to bail out, that resulted in such fears of counterparty risk that transactions on financial markets almost dried up in the third and fourth quarters of 2008. The shortage of working capital causes desperate firms to liquidate stocks, slash purchases of parts and components, and fire staff. Trade finance became scarce and falling purchases by firms and consumers international trade began to plummet.
Claiming that they had learned the lessons of the 1930s, governments and central banks took aggressive steps to stabilise national economies. This second phase of the crisis involved interest rates being cut to almost zero, liquidity being made available in substantial quantities to financial market institutions, purchases of a range of financial assets by central banks, and the implementation of large fiscal stimulus packages. The stabilisation phase started in the fourth quarter of 2008 and continued through to the end of 2009.
Convinced that the worst was over and expecting that national incomes would recover in 2010, fears arose that stimulus packages, if continued, would create unsustainable public debts, which in turn would induce falling bond prices and rising medium and longer term interest rates. Since many such bonds were owned by banks and pension funds it was feared that unless steps were taken to reduce government borrowing then falls in the value of government bonds would risk the solvency of these private sector financial institutions. This is the first example during the crisis of what became known as bank-sovereign linkages, implying that their fates could be linked.
From 2010 on, then, the third phase of the crisis began with austerity plans announced involving, in principle, tax increases and government spending cuts. These measures were controversial, as some thought that their implementation was premature given national economies had not returned to their previous growth paths. Still, it was argued that austerity, coupled with structural reforms to raise the long run rate of growth of economies would raise expectations of future tax levels and allay fears about the long term solvency of governments.
Austerity was combined in many industrialised economies with higher rates of personal saving as individuals sought to pay down their debts and to rebuild their financial portfolios. Sharp falls in housing prices in some jurisdictions plus the effects of holding foreign financial assets that had fallen considerably in value implied that many banks held substantial bad debts. During the process of recognising and writing off these bad debts bank lending for new projects was depressed. The combination of austerity, deleveraging, and rebuilding bank balance sheets meant that economic growth fell below projections for many large economies during the years 2010 to 2012. Public and expert discontent with austerity measures grew.
Although the International Monetary Fund began publicly questioning austerity in the third quarter of 2012, it was not until 2013 that austerity policies were called into question by previous adherents (such as the President of the European Commission) and demoted, if not abandoned. This led to the fourth and latest phase of the crisis, where the emphasis is on structural reforms, including not just banking reforms but also labour and product market reforms.
In the Eurozone countries, concerns about the solvency of several governments reached such heights that they added another dimension to the global financial crisis. The governments of Greece, Ireland, Malta, and Portugal were unable to borrow from the financial markets and sought bailouts from the Troika, the IMF, the European Commission, and the European Central Banks. EU member states and the IMF put up the funds for the bailouts. Greece needed several bailout packages, the last of which saw a large portion of its government debt written off. In July 2012 Spain agreed to a €100bn deal with the European Central Bank to bailout out that country’s banks, it being believed that the Spanish government did not have the resources to do so.
When fears reached their peak that the governments of Italy and Spain, two much larger economies, may not be able to sell enough government bonds, on 26 July 2012 the President of the European Central Bank threatened to intervene as aggressively as necessary to keep yields on those bonds down. Since then the interest rates on Italy and Spain’s government debts have fluctuated in a relatively stable range.
 For an account of the different types of financial crises see http://www.imf.org/external/pubs/ft/wp/2013/wp1328.pdf
 For a timeline of the crisis through 2010 see http://lauder.wharton.upenn.edu/pages/pdf/class_info/Chronology_Economic_Financial_Crisis.pdf