Financial Crisis and Stock Market Crash Essay

Submitted By jgallop
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John Gallop EH101 13/3/15 (Group 11 Franz Zobl)
Does historical experience suggest that financial crises are the result of weak economic fundamentals or self-fulfilling panics?
A financial crisis is ‘a disturbance to financial markets – associated with falling asset prices and insolvency, which spreads through the financial system, disrupting the market’s capacity to allocate capital.’1 Nearly all crises feature both weak fundamentals of some sort and a period of panic. If a fundamental becomes irreparably weak – that is to say a country has become insolvent - then a crisis is inevitable. However a panic is a symptom not a cause of crisis and arises as a result of an external trigger. Accordingly, crises are a result of weak fundamentals, which I will show by reference to several historical experiences.
The process of a crisis2
A crisis usually has a benign beginning and often starts following a welcome shock to the macro-economic system. For example the 1980’s Latin American (LA) debt crisis arose out of excess Western bank deposits post the ’73 oil price hike (petro-dollars) whilst the 1987 stock market crash was born out of the market liberalisation known as ‘big bang’ in 1986. This macroeconomic shock/change often fuels an expansion in credit and allows an economy to begin to over-heat. The first fundamental weakness comes when the regulatory system fails to moderate the economy allowing mania buying/lending/investing to develop during which other fundamentals weaken. Such was the case in the South East Asian (SEA) crisis of 1997. A sudden shift in risk perception might then occur to throw a particular fundamental weakness into sharp focus. In October 1987 the Iranians fired at ships in the Gulf and in September 2008 Lehman Brothers collapsed. Fundamentals had not changed but risk perceptions based on one or more of the fundamentals had altered and realisation of a problem dawned on lenders/investors - the Wile E Coyote moment3!
Wile E Coyote demonstrates ‘the moment!’
The international community then leaps into action, for example the IMF arranged interim lending to Mexico when it threatened default in 1981. However these actions can only succeed if the underlying fundamental weakness has fallen to a point where the debtor country remains solvent but illiquid.

The weakening fundamentals 4
Liberalisation, regulation and policy. Nearly all crises reveal a degree of failure in the area of financial liberalisation coupled with inadequate financial regulation and sometimes poor/ inconsistent policy decisions. The failure of the FSA and Bank of England to moderate mortgage lending prior to 2007/8 contributed to the banking crisis which emerged. I have already mentioned a similar failure of regulators in SEA in the years before 1997 and in that crisis regulators exacerbated matters by ‘flip-flopping’ – adopting inconsistent policies.
Rising Asset prices.

Sharp asset price rises highlight pride before a fall. Asset bubbles always burst and growth rates should be monitored.

Left: the 2007 house price bubble is clear, as is the rapid recovery by 2010.

Slowing GDP growth.

Left: The solid black line shows waning US GDP growth in the years before the ‘great recession’ took hold (2007 is ‘t’).

Rising current account deficit.

Left: The US deficit as a % of GDP increased 2003-6.
Increasing debt.

A sustained and exponential growth in domestic and/or international debt is a clear sign of a weakening fundamental, particularly if combined with any of the other factors in this list.
It is rare for all the fundamentals listed to show weakness prior to a crisis although Rogoff suggests that all the above were ‘blinking red’ prior to the Great Recession5.
Self-fulfilling panic
Financial panic occurs when international creditors suddenly change expectations and lose confidence. For example in an asset-bubble panic creates real losses whereas delaying sales might have allowed prices to return…